Chapter

2 Financial and Enterprise Restructuring in Emerging Market Economies

Editor(s):
Timothy Lane, D. Folkerts-Landau, and Gerard Caprio
Published Date:
June 1994
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Author(s)
Steven M. Fries and Timothy D. Lane1 

Building sound financial systems is fundamental to developing viable market economies where central planning once prevailed. In a market economy, it is the financial system that channels savings among alternative uses, either through competing intermediaries or in markets, guiding the composition of economic activity and its rate of expansion. Accompanying this provision of financing are various forms of control over the use of capital—the voting rights of shareholders, restrictive covenants in lending agreements, and shifts in control associated with bankruptcy. Within the discipline thereby imposed, a market economy permits a large degree of decentralization. The transformation from a centrally planned to a market economy thus entails, in large measure, a shift from bureaucratic administration to financial control.

Financial restructuring in emerging market economies is not only limited to building a sound financial system that effectively controls the use of capital. The economic and financial structure of state-owned enterprises (SOEs), including their privatization, is also of crucial importance. For the transformation to a market economy to enhance efficiency, it must change the organization and deployment of productive resources—including paring down large SOEs from their often vast scale and scope and liquidating chronic loss-making enterprises. In the void created by the breakdown of bureaucratic administration, strengthening financial control can be an important means of achieving this economic restructuring. Enforcing existing debts can be used to force inefficient SOEs to shed physical assets, while providing new financing to support enterprise sell-offs and leasing can facilitate the transfer of productive assets into the nascent private sector. However, the financial structure of new private firms, which shapes the incentives faced by their owners, creditors, and managers, should reflect their preferences rather than those of a central authority.

Because of both the discipline imposed by a sound financial system in a market economy and the need to provide finance for economic restructuring, an overhaul of the financial systems in emerging market economies is of pressing importance. This overhaul includes not only an upgrading of the physical and human capital of banks and other financial institutions, but also a fundamental shift from finance as the passive record-keeping mechanism under central planning to finance as the primary instrument of control over the use of capital.

The legacy of bad loans from the era of central planning and the early period of transition to a market economy, however, severely hampers the overhaul of both state banks and SOEs in some emerging market economies. These doubtful loans were made mostly to SOEs by state banks; in some cases, they constitute substantial proportions of both state bank assets and enterprise liabilities. State banks are also hindered by the sectoral and geographical concentration of their loans that resulted from their typical origins as either regional offices of monobanks or as specialized financing agencies for particular industries.2

This paper examines alternative approaches to building sound financial structures in some emerging market economies. The foremost task is to resolve the bad loan problem and to recapitalize insolvent state banks. By restoring an incentive for banks to price accurately the risks of new lending, the resolution of bad loans would be an important first step in strengthening financial control. However, this endeavor is only part of the task at hand; the remainder is to provide financing that facilitates the economic restructuring of SOEs. A comprehensive strategy may combine discipline derived from enforcing existing loans to SOEs with adequate funding for new forms of ownership, including financing for enterprise sell-offs and leasing.

Origins of the Bad Loan Problem

Although loan defaults did not occur under central planning, the origins of the current bad loan problem in some emerging market economies can be traced to the old system. Under the monobank structure, a single bank performed both commercial and central banking functions. In commercial banking, a monobank typically played a passive role, providing book-entry credit to SOEs for all investment projects approved under the central plan and disbursing cash for payment of wages. An attempt was usually made to maintain a strict separation between cash and credit money: the former was used for wages and household consumption and the latter for interenterprise transactions. Since credit money could not be spent without the planners’ approval, and credit could be created automatically with the planners’ approval, the lending decisions of the monobank were not guided by the opportunity cost of funds or by the ability to repay. The concept of bad debt was therefore irrelevant. Because the enterprise sector as a whole was typically solvent—being the main source of revenue for the government—the creditworthiness of individual SOEs was not of primary concern to planners.

In many of the centrally planned economies, the initial reform efforts scaled back central planning and granted more autonomy to SOEs. At the same time, more banks were created. In some countries, such as Poland, the monobank’s commercial banking functions were devolved onto newly created commercial banks, whereas in others, such as Russia, many new banks were established. However, bank operations adapted slowly to the greater degree of decentralization.

Without both the constraints imposed by central planning and effective financial control, SOEs stepped up their borrowing. Sharply negative real interest rates in some countries further stimulated this effort. Moreover, where high real interest rates prevailed, the adverse selection may have impeded the efficient allocation of credit. Since banks had not begun to discriminate between borrowers’ creditworthiness, high interest rates may have discouraged borrowing by solvent enterprises whose managers and workers expected to have a stake in the firm, whereas those SOEs whose debt far exceeded their assets may have been undeterred, never expecting to have to service the new lending (see Dooley and Isard, 1992).3 Restrictive credit policies, compounded by shortcomings in credit and payment systems, may also have contributed to the overall deterioration of the enterprise sector in some countries (Calvo and Coricelli, 1992 and 1993).

The large shocks to which SOEs in Central and Eastern Europe were subjected in the early 1990s were another source of the bad loan problem. First, price and trade liberalization worked to undermine the profitability of the enterprise sector: SOEs that had produced goods subject to shortages, purchasing inputs at controlled prices and selling their output under conditions of excess demand, suddenly hit the demand constraint. Many enterprises faced a large contraction in demand and were unable to adapt to altered market conditions (Blanchard and others, 1991; and Borensztein, Demekas, and Ostry, 1993).4

Second, the breakdown of trade among the countries of the former Council for Mutual Economic Assistance (CMEA) and among the states of the former Soviet Union exacerbated the plight of the enterprise sector (Rodrick, 1992). This breakdown was intensified by deep distrust among some of these countries and because the previous pattern of trade had been to some extent artificially promoted in the interest of maintaining fraternal relations among the socialist countries (Wolf, 1990). The shocks affecting the enterprises, together with the banking system’s failure to discriminate according to creditworthiness, contributed to substantial further accumulations of bad debt after some reform programs had begun.

The pattern of lending in the initial period of reform illustrates three aspects of the lack of financial control. First, many SOEs were confronted with permanent changes in their economic setting—in their input prices and in markets for their outputs—that would not permit them to survive in their present form; nevertheless, these SOEs continued to receive bank credit that enabled them to perpetuate chronic loss-making activities.5 Second, reflecting the breakdown of central control of SOEs, some enterprise managers may have used their access to credit to buy industrial peace by granting higher wages (Coricelli and Lane, 1993) or to further their own interests, expecting that the debts would be serviced by someone else.6 Third, the explosive growth in interenterprise arrears after initiation of reform programs may also point to the lack of financial control, although some growth in this form of credit may have reflected normal business practices (Clifton and Khan, 1993; and Ickes and Ryterman, 1993).

Why did banks not exercise a greater degree of financial control after the initiation of reforms? First, they had no clear-cut incentive to maximize profits, since they remained under state ownership. Even where their profits were shared with employees, uncertainty about how long this arrangement would last may have given them a very short-term perspective. Second, those banks that were themselves insolvent had no incentive to withhold credit from unworthy borrowers. Under these circumstances, lending to enable insolvent debtors to service their obligations could be rational, since it enabled the troubled banks to report the loans as performing, and thereby postpone the day of reckoning (Mitchell, 1993). Third, the quality of information on outstanding debts was very poor, because few facts were available on which to assess the long-term viability of SOEs or even the quality of their receivables from other enterprises. Finally, the strength of insider networks and customary relationships may have perpetuated lending patterns established in the era of central planning.

The bad loans in emerging market economies are a serious problem because they distort the incentives of both creditors and debtors. Banks whose bad loans are so large that they are insolvent do not make efficient lending decisions, since at the margin no incentive exists to price accurately the risks of new loans. Under these circumstances, a serious moral hazard problem could arise, as managers of state-owned banks would see little benefit from prudent lending relative to a high-risk gamble that could keep them in business. Moreover, as long as banks are saddled with such a large proportion of nonperforming assets that they have negative net worth, they cannot be privatized. Bad loans also pose a similar moral hazard problem for insolvent SOEs, destroying the incentive for maximizing enterprise profits and significantly impeding their privatization (Levine and Scott, 1993).

Fiscal Constraints in Emerging Market Economies

To eliminate quickly the moral hazard problem associated with the debt overhang and to pave the way for privatization, sweeping solutions to the bad loan problem have been suggested. These involve either debt cancellation—eliminating claims of state banks on SOEs and of SOEs on one another—or debt socialization—replacing existing bank loans to SOEs with claims on the government’s budget (Calvo and Frenkel, 1991; Begg and Portes, 1993; Calvo and Kumar, 1993; and Levine and Scott, 1993). However, any such solution to the bad debt problem must take into account its impact on the fiscal position of the government overseeing the transition to a market economy. This impact arises largely from the extent to which the government guarantees deposits in state banks, which usually account for the bulk of the private sector’s claims on the public sector.

The government’s ability to raise revenues with which to fund a bailout of depositors is limited, however. In emerging market economies, revenues are largely derived from the enterprise sectors, whose profitability has been squeezed by initial reform efforts (Tanzi, 1991 and 1993). Steps have been taken in some countries to move toward new tax bases—such as personal income tax and value-added taxes—but new forms of taxation often take time to yield much revenue.7 In parts of the former Soviet Union, this problem may be exacerbated by disagreements on the right to tax the enterprises, and on the ambiguity of property rights in general (Shleifer and Vishny, 1994). This suggests that, if a debt write-off or socialization further reduces a government’s ability to derive revenues (including debt service payments) from the enterprise sector, a heavier burden would fall on those forms of taxation that can be most readily collected, including the inflation tax (Lipton and Sachs, 1990).

The fiscal constraint would be less binding if there were well-developed markets for government securities (bills and bonds). Such financing opportunities would permit the government to achieve its desired intertemporal distribution of the tax burden. The appropriate choice of intertemporal tax incidence would then depend on anticipated improvements in tax collection and on expected increases in income over the long haul to minimize the deadweight losses from the taxation. This choice could also take into account intergenerational equity, possibly shifting to future generations some of the costs of the economic transformation from which they will likely benefit in the form of higher incomes. However, in many emerging market economies, the absence of well-developed money and securities markets limits the amount of government debt that can be sold to finance the cancellation of old loans.

The debt socialization proposal aims to avoid large-scale sales of government debt into underdeveloped markets by swapping these obligations for the claims of banks on SOEs. As a first approximation, debt socialization is equivalent to lending by insolvent banks that benefit from an official guarantee of their deposits, substituting an explicit liability of the government for its contingent liability. Two key differences make debt socialization preferable, however. It is more transparent, recognizing the transaction as a financing item in the government’s budget rather than as a contingent liability; and it paves the way for solving the moral hazard problem associated with insolvent banks and SOEs.

If the debt socialization approach is followed, however, how much debt should be socialized and what should a government do with the claims that it obtains on the SOEs? As a starting point, it is assumed that the state banks are to be privatized. If this privatization takes place by selling shares in a liquid equity market, the net fiscal cost of any debt socialization is limited to the negative net assets of the bank, because the government recoups the amount of any excessive debt socialization through increased privatization revenues (Begg and Portes, 1993). However, if—as seems more realistic—banks are sold in relatively illiquid equity markets, or if they are given away to the public through some kind of voucher scheme, the benefits of excessive debt socialization are unlikely to be fully reflected in share prices, and thus would to some extent accrue to the new owners of the banks.

With respect to the claims on SOEs that governments would receive from banks, such debts could be retained at least in part to impose financial control over the managements of SOEs and to bolster government revenues. Provided that these debt contracts can be enforced, they could be used to pry productive resources away from inefficient SOEs. If financing for enterprise restructuring is available, the existing debts of SOEs could be used to mop up free cash flows that may be generated by the sale of productive assets (Jensen, 1986). Also, with respect to profitable SOEs, the existing debts could limit the discretion of managers over the use of operating profits. In both cases, the existing debts of SOEs could also provide the government with a source of revenue. However, the fiscal benefits from enforcing the existing debts of SOEs must be counterbalanced against the adverse incentives faced by the managers of insolvent SOEs.

A blanket solution to the bad loan problem in emerging market economies, such as a generalized debt socialization or write-down, is unlikely to strike the appropriate balance between quickly restoring solvency to banks and SOEs and limiting the fiscal impact of a bailout. An indiscriminate bailout would not promote the restructuring of SOEs needed to achieve more efficient deployment of productive resources and more competitive market structures. Rather, to resolve the bad loan problem, a case-by-case approach is necessary.

Resolving the Bad Loan Problem of State Banks

It is perhaps best to begin with the state banks, since the provision of new, high-quality loans and other services is key to strengthening financial control and to restructuring the enterprise sector in emerging market economies. With respect to the banking overhaul, several important issues must be addressed. First, the responsibility for undertaking the resolution must be assigned. Two alternative approaches are a decentralized route, in which responsibility for resolving the problem rests with the banks themselves, versus a centralized approach carried out through a specialized agency. The second issue is whether the banks should be recapitalized and, if so, how this should be accomplished. Finally, as with any bailout, the moral hazard problem must be combated, which in this case requires the privatization of banks.

Decentralized Versus Centralized Strategies

One approach to resolving the bad loan problem is to leave the individual banks that are so burdened to sort out the problem, as in the decentralized strategy recently adopted in Poland to address the bad loans of its nine major commercial banks. In this case, a certain portion of the banks’ doubtful loans were segregated in their balance sheets and subjected to special monitoring. This approach has also been used in Argentina, Malaysia, the Republic of Korea, Thailand, and the United Kingdom (during the secondary banking crisis).8 An alternative approach is to carve out bad loans from the banks’ balance sheets and to transfer them to a centralized agency created by the banks or the government to resolve the bad loan problem. Recent examples of this approach are the creation of the Resolution Trust Corporation in the United States, the Cooperative Credit Purchasing Company in Japan, and the Spanish Guarantee Fund. This approach has also been used in Chile, the Philippines, and Uruguay.

The experience in industrial and developing countries reveals that the choice of a decentralized or centralized strategy for resolving the problem often reflects a number of factors. Foremost among them appears to be the size and scope of the problem (Saunders and Sommariva, 1993). In banking crises that involve a large number of problem banks with a substantial proportion of the banking system’s loans, the doubtful assets are often transferred to a restructuring agency. In the other cases, a more decentralized approach is typically used, in which individual institutions retain responsibility for resolving the bad loan problem.9 By both official and unofficial accounts, the number of troubled banks and the proportion of doubtful loans in some emerging market economies are very large, calling for the use of a centralized solution.

In addition, a number of unique factors have a bearing on the appropriate choice of a resolution strategy in an emerging market economy, some of which also weigh in favor of the centralized approach (Blommestein and Lange, 1993). First, this approach decouples the banking overhaul from enterprise restructuring and may help to sever the symbiotic relationship between banks and SOEs. Because the restructuring and privatization of large SOEs is likely to be protracted, retaining bad loans to SOEs on the balance sheets of banks may impede the banks’ overhaul. The relatively quick rehabilitation of banks’ balance sheets afforded by the centralized approach would allow the management of these institutions to turn to the business of making new, high-quality loans. Moreover, the substantial reduction in banks’ credit exposure to loss-making SOEs would be an important first step in breaking the spiral of bank lending to support these troubled enterprises. If banks are adequately recapitalized when the bad loans are removed from their books, they would no longer be compelled to roll over old loans to maintain the pretense of solvency. However, regulations to curb new bank lending to SOEs—for example, rules pertaining to large exposures—may be necessary to establish an arm’s-length relationship between banks and SOEs and to encourage the formation of broadly diversified loan portfolios.

In contrast, if the bad loans are retained on the balance sheets of banks, their close relationship with SOEs would probably be preserved, as would the banks’ concentrated credit exposures. Although in principle banks could be recapitalized sufficiently to enable them to charge off the nonperforming loans, the resolution of the bad loans could require the banks to become closely involved with the managements of SOEs. This involvement would not be limited to isolated business failures, but would be pervasive, given the financial condition of the enterprise sector. The extensive commingling of banking and commercial activities has been resisted throughout much of the history of Anglo-Saxon banking (Corrigan, 1991). The two main concerns have been about conflicts of interest and concentrations of economic power. Delegating enterprise restructuring to banks may thus impede the paring down of large SOEs. However, in other countries, such as Germany, the cartelization of banking and industry has been viewed as an engine of development (Hellwig, 1991).

The second consideration that favors a centralized approach is the pace at which bank privatization could proceed. The cleaning up of banks’ balance sheets would enable them to be more precisely valued and reduce the time required for due-diligence investigations before their sale. Moreover, privatization in this manner is likely to be more enduring because it makes a clear break with the past. The government could credibly argue that any losses on loans are in the first instance the responsibility of banks’ private owners and managers (Levine and Scott, 1993).

Third, a centralized resolution agency may facilitate the restructuring of SOEs. One impediment to their restructuring is the diffuse control of SOEs with the loss of central government authority after the collapse of communist regimes. Workers, incumbent managers, and local governments now vie for dominant positions in these enterprises (Dinopoulos and Lane, 1992; van Wijnbergen, 1992; and Shleifer and Vishny, 1994). In bargaining with these various stakeholders, an agency backed by the government may have greater authority and leverage than banks. In principle, the agency must devise a resolution strategy that combines enough “carrots and sticks” to prevent these stakeholders from blocking the restructuring of enterprises. One possible incentive is the transfer of shares in privatized enterprises as needed to one or more of these groups (van Wijnbergen, 1992), whereas channeling new bank loans away from chronic loss-making SOEs toward enterprise restructuring is a potential way to discourage obstruction (Perotti, 1992).

The main argument against adopting the centralized approach is that the administrative demands of this solution would be difficult to satisfy in many emerging market economies, where such expertise is in short supply. This, in fact, was the main reason why the Polish Government opted for a decentralized approach to resolving the bad loan problem of its nine largest banks (Kawalec, 1994). A centralized agency may also become a focal point for rent-seeking activities that could undermine its efforts to restructure enterprises, although individual banks would not be immune to such pressures.

Bank Recapitalization

Given an assignment of administrative responsibility for resolving the bad loan problem, the issues arise of whether and, if so, how, the banks should be recapitalized. The case for recapitalizing insolvent banks rests on several considerations. Two of the more important are the building of confidence in the banking system and the preparing for the privatization of state banks. Failure to protect depositors would risk financial instability and jeopardize the attempt to impose market discipline through financial control. At the same time, recapitalization is a necessary first step for the sale of banks to private investors to help combat the moral hazard problem associated with a bailout of depositors (see below). Concern over the fiscal impact of the bailout, however, could lead to the imposition of losses on depositors, especially through high inflation and negative real deposit rates, or to the adoption of inefficient schemes that attempt to hide its true cost.

Many industrial countries experienced periods of financial instability, particularly in the 1930s and in periods surrounding major wars, that involved widespread failures of financial institutions, sharp declines in asset prices, and disruptions to payment systems and credit intermediation. The perception that this instability contributed to significant declines in real activity and employment have led most industrial countries to adopt financial policies aimed at promoting financial stability and at containing the spillover effects from financial crises onto the real economy. These policies include extensive explicit and implicit guarantees of bank deposits.

The official safety net for banks and other financial institutions in industrial countries consists primarily of the central banks’ authority to act as lender of last resort, typically on the basis of collateral, and explicit deposit insurance schemes. The structure of these schemes differs widely, however, in terms of the extent of their coverage, the institutions allowed or obligated to participate, the relative roles of private and public insurance, and the extent to which insurance funds have been used. Nevertheless, in instances of financial instability, authorities typically have come quickly to the rescue of troubled institutions, mobilizing both public and industry resources. For troubled banks, preserving confidence in the system has usually necessitated providing enough liquidity to protect depositors and to give time until the situation could be fully assessed and resolved in an orderly fashion (Corrigan, 1990).

In emerging market economies, the potential for financial instability is substantial. Initial reform efforts have seriously impaired the financial position of many SOEs and, in turn, that of their creditor banks. Moreover, owing to a lack of reliable accounts and financial disclosures, the distribution losses within banking systems are largely unknown to depositors. To maintain financial stability and to lay the foundation for the shift to financial control over the use of capital, many governments overseeing transitions to a market economy have pursued a policy of de facto guaranteeing 100 percent of deposits in major state banks, notwithstanding their loss in value through inflation as in Russia.10

The choice of recapitalization often reflects the trade-off among conflicting objectives, in particular maintaining financial stability versus minimizing fiscal costs.11 In industrial countries, attempts to strike a balance between these goals, however, sometimes have led to efforts aimed at concealing the true cost of recapitalizations, which often raise their ultimate costs. For example, governments can sufficiently restrict competition among banks, allowing them to earn extraordinary profits from wide net interest margins that can be used to rebuild their capital. This approach, while keeping the recapitalization costs off the government’s books, imposes an equivalent burden of distortionary taxes on consumers of banking services to fund the recapitalizations. This is not in general an efficient way to distribute the tax burden. In the early stages of the U.S. savings and loan crisis, the deposit insurance agency resorted to the widespread use of loan guarantees to avoid making cash outlays. These guarantees, which weakened the incentive to collect on problem loans, ultimately proved to be very costly.

In emerging market economies, the status quo of allowing banks with negative net assets to continue operating with the benefit of a de facto 100 percent guarantee of deposits has appeal, because in part it conceals the true cost of bank recapitalizations. In such circumstances, the government effectively borrows by having state banks issue deposits and using the proceeds to fund their negative net assets. The status quo has appeal also because the interest on this borrowing is paid by creating additional bank deposits, rather than by using government revenues. However, allowing banks with negative net assets to continue their operations runs the danger of escalating the bad loan problem, because little incentive exists to collect on old loans or to price accurately the risks of new lending.

Any effort to recapitalize banks in emerging market economies thus must overcome the appeal of the status quo. One way to tip the balance in favor of explicit recapitalization is to craft a plan that to some extent replicates the present situation. Since both the banks and the SOEs fall within the public sector, banks can be recapitalized by the government exchanging its debt for bank claims on the SOEs. This balance sheet operation does not affect the consolidated net worth of the government, taking into account its commitment to depositors. Thus, in effect, this method of recapitalizing banks simply substitutes explicit government borrowing for its implicit borrowing in the form of bank deposits.

Although it is possible to craft recapitalization plans that largely replicate the status quo, any explicit recapitalization of banks would make the costs transparent. This transparency could impose political costs on the government and run afoul of attempts to achieve targets for benchmark levels of the fiscal deficit—which is of particular concern to international financial institutions. Nevertheless, an explicit recapitalization would allow the authorities to establish accountability for keeping these costs at a minimum.

Moral Hazard and Bank Privatization

In most official efforts to recapitalize troubled banks, the government’s aim of preserving financial stability cuts against the need to maintain market discipline for banks, as the losses are not confined to their shareholders and private creditors. Indeed, the fundamental dilemma is that, while official assistance can limit the impact of financial instability on real activity and employment, the expectation that such assistance will be forthcoming may alter the behavior of banks’ managers, shareholders, and unguaranteed creditors in such a way as to make future instability more likely (Lane, 1993).

In industrial countries, the moral hazard problem associated with the official safety net for banks is combated in several ways. First, replacement of the bank’s management is typically a precondition for official assistance to a troubled institution. Second, the shareholders’ claims on the bank are substantially diluted or written off in return for government assistance. Thus, the management and shareholders of a troubled bank bear the costs of failure to the fullest extent possible. Third, to minimize the likelihood of failure, governments implement comprehensive systems of banking regulation, including capital requirements, limits on concentrated credit exposures, and prudential examination.

The present banking troubles in emerging market economies do not, in the first instance, pose precisely the same moral hazard problem as those in industrial countries, since the government is the principal shareholder in the banks. By virtue of the de facto 100 percent deposit guarantee, the government is essentially a shareholder with unlimited liability and, thus, internalizes fully the costs of the banking troubles. Also, although bank managers in emerging market economies may not have acted entirely in the interests of the government, establishing accountability at the level of bank management is hampered by the short supply of capable managers. Significant redundancies in banking industries are simply not feasible.

The first line of defense against future banking troubles in emerging market economies is thus privatization of the banks and a credible government commitment not to protect the private shareholders. The most effective preventative measure against future troubles is placing private capital truly at risk in the banking system. With private capital at stake, the banks’ owners would have an incentive to ensure that risks of new lending are appropriately priced and that risk management procedures are adequate. If future losses are sustained, the private capital would serve as an initial buffer to absorb these costs, before recourse is made to public funds. The government’s commitment not to protect bank shareholders in the event of future losses would be made more credible by removing the bad loans to SOEs from the banks’ balance sheets before their sale (Levine and Scott, 1993).

Overhauling State-Owned Enterprises

The other side of the bad loan problem in emerging market economies is the restructuring or liquidation of SOEs that cannot service their debts. In principle, a bad loan can be restructured to reduce its principal amount or the present value of its interest payments. This approach typically enables the borrower to continue operating as a going concern at the expense of bank profitability over time. Alternatively, the operations of the borrower can be wound up, with the creditor receiving the proceeds from the disposition of assets. The unpaid loan balances must then be charged off. Moreover, these two types of resolution are sometimes undertaken simultaneously, in which case partial asset sales are used to pay off some debts, while others are restructured in a way that reduces their net present value.

Whereas formal bankruptcy proceedings provide one forum for resolving bad loans, restructurings and liquidations (or combinations thereof) can also be achieved, often at lower cost, through bargaining between creditors and debtors. However, the credible threat of enforcing the loan agreement (by seizing collateral) or the risk of bankruptcy often underpins such negotiations (Huberman and Kahn, 1988; Hart and Moore, 1989). The reform of bankruptcy and related laws would thus facilitate the overhaul of SOEs; however, the passing of legislation and the building of administrative capacity are time consuming (Aghion, Hart, and Moore, 1994; Mitchell, 1993). A centralized resolution agency can also perform some of the functions of bankruptcy proceedings, as well as allow for the social benefits and costs associated with enterprise restructuring.

Restructuring Versus Liquidation

Evidence from industrial countries, while limited, confirms the general preconception that firms filing to restructure their liabilities in bankruptcy tend to be larger and in better financial condition than those seeking to liquidate. However, the net assets of both types of firms are on average significantly negative.12 A study conducted for the U.S. Department of Justice found that the average ratio of total assets to liabilities of firms that file for Chapter 11 bankruptcy was 0.71, while that of firms that filed for Chapter 7 bankruptcy was 0.14 (Ames and others, 1983, as reported in White, 1989). The ratio of assets to secured liabilities of these two types of firms was 1.67 and 1.0, respectively.

One reason that loss-making firms may seek to restructure their liabilities is the ability gained to generate an adequate stream of profits with a lighter debt burden (Fries, Miller, and Perraudin, 1993). Such a restructuring also preserves the firm’s value as a going concern Jensen, 1989). However, if the firm’s losses are large enough, debt restructuring may not sufficiently improve the outlook for profits, in which case the firms are liquidated.

The choice between informal debt restructuring and bankruptcy proceedings appears to be influenced largely by the presence of a dominant creditor. In the United States, private negotiations over debt restructuring are more likely to succeed if banks are the primary creditors and less likely to succeed if there are a number of distinct creditor groups (Gilson, Kose, and Lang, 1990). It is widely believed among practitioners that costs of informal debt restructuring tend to be less than those of bankruptcy. Similarly, in Japan, where informal debt restructurings are not uncommon, a distressed firm with close ties to a main bank tends to perform better than a distressed firm with no such ties (Hoshi, Kashyap, and Scharfstein, 1990). One interpretation of these facts is that a dominant creditor can effectively serve to keep the costs of financial distress to a minimum.

The restructuring or liquidation of SOEs is subject to several constraints, however. First, the absence of well-functioning bankruptcy procedures limits the amount of restructuring or liquidations that could be undertaken through the courts. Bankruptcy laws in emerging market economies are relatively new and untested, with Hungary, Poland, and the former Czechoslovakia enacting such legislation in 1990-91 (Aghion, 1992). Only in Hungary, where the bankruptcy law came into effect at the beginning of 1992, have there been a significant number of bankruptcy petitions. By the end of 1992, the Hungarian courts had registered 3,658 restructuring and 7,062 liquidation applications (9 percent of enterprises with 33 percent of GDP).13 However, only 27 percent of these cases have been completed owing to limited court capacity.

Even if the legal capacity existed, the substantial social benefits and costs associated with enterprise restructuring may point to the need for a resolution that does not focus narrowly on the interests of creditors. If prevailing structures of large SOEs, with their extensive vertical and horizontal integration, were left intact, productivity gains from a more efficient deployment of productive resources would be forgone and the risks of monopoly abuses would be high (Carlin and Mayer, 1992).14 In addition, the unemployment consequences of enterprise restructuring are often serious because SOEs provide housing and other social services and prolonged because of the relative immobility of workers (Dooley and Isard, 1992).

Finally, the lack of effective recourse to bankruptcy undermines the ability of banks and SOEs to reach an informal agreement on the resolution of bad loans. The absence of restrictive loan covenants that could give creditors leverage by threatening to seize collateral or to restrict enterprise operations in other ways also undermines the bargaining position of state banks.15

Resolution Agency’s Role in Restructuring

The above considerations—creditors with little leverage to restructure debt outside the courts, nonexistent or poorly functioning bankruptcy procedures, and significant social benefits and costs to restructuring—argue for a resolution approach that does not conform precisely to approaches in industrial countries. The Treuhand, a government agency charged with responsibility for restructuring and privatizing east German SOEs, provides such an example. In effect, a government agency can compensate for shortcomings in the legal framework, including corporate governance, and allow for social benefits and costs (Carlin and Mayer, 1992).

The Treuhand has among its main functions: evaluating the balance sheets of SOEs and writing off their old debts; reorganizing and closing enterprises; and setting employment and investment targets. The Treuhand called upon a team of west German managers to analyze the potential viability and balance sheets of east German SOEs. Its evaluation of viability was based on whether SOEs had marketable products, capable managements, and links with west German firms. To mitigate the initial arbitrary conditions imposed on SOEs by their inherited debts, the liabilities to the state bank of the former east German regime were written down to the point at which their equity was in line with that of comparable west German firms.16 The Treuhand’s power to restructure enterprises stems from a 1991 law that allows it to carve out parts of SOEs for sale. If necessary, the Treuhand can circumvent management opposition to restructuring by dismissal. Finally, although the net worth on the adjusted balance sheets of SOEs serves as a benchmark, the Treuhand adjusts sales prices in privatizations according to the investments that the buyers guarantee to undertake and the number of jobs that they preserve.

Although the majority of enterprises will be restructured and privatized, recent estimates indicate that between 20 and 30 percent of east German SOEs will be liquidated. The industries slated for the greatest share of enterprise closures are mining, metal goods, leather-ware, synthetics, textiles, electronics, and chemicals—all tradable goods.17 Firms may be closed by liquidation under the auspices of the Treuhand or by a more formal court liquidation. The Treuhand liquidations tend to preserve where possible the value of enterprises as going concerns by carving out those parts that are viable and negotiating their sale to new investors. In formal bankruptcy proceedings, the Treuhand loses the power to dispose of assets, and the narrow interests of creditors tend to prevail. As a result, more jobs are preserved in Treuhand liquidations (33 percent) than in formal bankruptcy liquidations (23 percent).

The Treuhand’s approach of emphasizing the preservation of enterprise employment is not necessarily feasible in other emerging market economies, however. The criteria adopted by the Treuhand have no doubt been appropriate in east Germany, where the social safety net makes unemployment very costly from a fiscal standpoint, whereas the tax base of Germany as a whole is large enough to support an expensive bailout of SOEs. The massive increase in the costs of the Treuhand’s restructuring efforts relative to initial expectations may nevertheless represent one of the drawbacks of a centralized resolution agency. It may face considerable political pressure not to liquidate chronic loss-making enterprises, even when they have little prospect of returning to profitability. However, as pointed out above, individual banks may be subject to much the same pressure under a decentralized approach.

Other aspects of the Treuhand’s approach, while suitable for east Germany, may also be less applicable to other emerging market economies. These include the heavy reliance on expertise, and the introduction of the established legal system, from west Germany. Such an extensive use of “outsiders,” let alone the wholesale introduction of laws and law enforcement procedures from outside, would not be possible nor politically acceptable in other countries in transition.

These considerations suggest that, in other emerging market economies, a resolution agency may adopt a more narrowly focused and less costly approach than that of the Treuhand. For example, such a government agency, as the holder of claims on SOEs after a debt socialization, could concentrate on enforcing these debts.18 This could include selling off viable parts of SOEs as going concerns and using the proceeds to pay off their outstanding debts. Enterprise assets could also be sold piecemeal to leasing companies that would, in turn, lease the structures and capital equipment to private firms. Provided that these asset sales are valued accurately (see below), this approach would effect the writing-down of outstanding enterprise debt to its market value and, at the same time, boost productivity and foster more competitive market structures. The strategy could be tailored to the agency’s administrative capacity, provided that tight controls can be imposed on SOEs awaiting restructuring.19

Financing for Enterprise Restructuring

While a resolution agency can play an important role in reducing the inefficient scale and scope of large SOEs and in creating more competitive market structures, such restructuring requires financing to acquire productive assets from the SOEs. In principle, the stock of private savings could be used for the purchase of these divested assets; however, their value may well outstrip the amount of private wealth, both domestic and foreign, that could be mobilized in the short run for this purpose (Aghion and Burgess, 1992). This constraint on asset sales could be eased if the government accepted claims on the cash flows generated by the assets (Bolton and Roland,1992).

To the extent that individual wealth is mobilized to acquire assets from SOEs, asset sales may classify potential buyers by their wealth rather than by their ability to use the assets efficiently (Bolton and Roland, 1992). If ability and wealth are not highly and positively correlated, asset sales to the private sector may not achieve the maximum possible efficiency gains from redeploying enterprise assets. The potential trade-off between the ability and wealth of those that purchase enterprise assets could be eased in several ways. First, restructuring of SOEs prior to their sale would lessen the amount of wealth required to purchase a particular set of enterprise assets. Second, the provision of financing to purchasers of divested assets by banks and private investors could ease the trade-off between wealth and ability. Finally, acceptance by the government of noncash bids (claims on cash flows) for enterprise assets could provide purchasers with an alternative source of financing.

What is the appropriate financial structure to support sell-offs from SOEs? The answer depends in part on the relationship between the new firm’s owners and its managers. In an owner-managed firm, management decisions are taken in the owner’s interest, but at the expense of a potential exposure to firm-specific risks. If ownership extends beyond the firm’s managers to include outside shareholders, risk is better diversified, but the managers must be given a stronger incentive to act in the owners’ interests. Mechanisms that serve to combat this incentive problem include managerial compensation contracts based on (noisy) measures of performance, monitoring by boards of directors, and shifts in control associated with bankruptcy.

The problems of constructing incentive contracts and monitoring are particularly difficult for firms operating under highly uncertain conditions (Tirole, 1992). This consideration is particularly important in emerging market economies, in which demand and cost conditions are often volatile. For example, highly sensitive performance contracts may expose managers to substantial risks beyond their control, while ex post monitoring of whether a firm lost money because of an adverse shift in market conditions or because of poor managerial performance could be difficult. One solution to the incentive versus risk-sharing problem appears to lie with having an inside shareholder group, which may involve a majority stake (Demsetz and Lehn, 1985), to solve the incentive problem, and outside equity investors to spread the risks. Moreover, high leverage in the face of great uncertainty risks frequent bankruptcies that do not necessarily reflect managerial performance.

To achieve the desired financial structure for enterprise sell-offs, external financing in the form of bank loans and outside equity must be available, in addition to the wealth of insiders. To facilitate the provision of debt financing by banks, sell-offs could be offered free of old debts. Private equity investors could then use the unencumbered assets to attract bank loans that could be used to fund part of the acquisitions. If sufficient bank loans cannot be mobilized, the government or resolution agency could retain a debt claim on the sell-off. The appropriate degree of leverage could then be gauged from comparable divestitures for which only banks provided the debt funding.

The provision of outside equity is, even in industrial countries, difficult and costly, especially for new firms. Initial public offerings in a number of industrial countries are on average priced at substantial discounts to their post-offering prices (Smith, 1986; and Jenkinson, 1990). This underpricing of initial public offerings reflects at least in part the limited information that investors and underwriters have about the prospects of firms tapping the equity market for the first time. This problem is likely to be more severe in emerging market economies. One solution is for the government to retain equity stakes in divested companies to achieve some spreading of risks during the initial high-risk period.20 These holdings could then be sold in tranches to develop a liquid market for the shares and to maximize the revenues from the sale to private investors. Public offerings of equities that are already traded on markets tend to be priced close to prevailing secondary market prices (Smith, 1986).

In addition to sell-offs, shifting economic activity to a smaller scale can be achieved by either bank affiliates or the government leasing productive assets. Leasing is partly an alternative to collateralized borrowing, which has the advantage of economizing on the amount of financing needed by the lessee (Smith and Wakeman, 1985). A lease needs financing for only the interest cost and the amount of the productive asset that is depreciated while in the lessee’s possession. Also, it has desirable incentive effects in that the lessee pays a fixed amount for use of the asset and receives at the margin the benefits from its efficient use. However, leasing has certain adverse effects not associated with outright ownership of an asset: the lessee has less of an incentive to invest in maintenance and improvement of the asset than if the asset were owned. Where it is difficult to specify such responsibilities contractually, there may be a moral hazard problem in which either the lessor or the lessee may refrain from undertaking investments that would be beneficial.

In emerging market economies, short-term leases have the desirable property of tending to lessen the need for information about the value of the asset being leased (Flath, 1980), whereas with outright sales, considerable information would have to be gathered about the value of the asset. In a period of rapid economic transition, when any valuation is highly speculative, this information could be very costly, if not impossible, to produce. With a short-term lease, the lessee only agrees to rent the asset’s services for a limited period; therefore, less is at stake in the initial valuation. In addition, the assets can be sold outright later when there is a sounder basis on which to value them.

Conclusion

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

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

Comment

Georg Winckler

The paper by Steven Fries and Timothy Lane, “Financial and Enterprise Restructuring in Emerging Market Economies,” is a comprehensive and well-written survey of the financial problems currently plaguing the previously centrally planned economies, especially in Central and Eastern Europe. The paper is well based on microeconomic and macroeconomic reasoning. Many of its issues will be discussed in more detail in specialized sessions over the next two days.

Owing to the paper’s excellent survey and because I agree with most of its contents it is hard for me to comment critically on the paper. I would like to add only two general points and comment on one specific issue. The first general point seeks to cast further light on the cause of the current financial difficulties in Eastern Europe, whereas the second one deals with the role of universal banks in solving these problems, a role somewhat neglected in the paper by Fries and Lane.

The cause of the current problems is related to what Steven Fries and Timothy Lane call the legacy of the past. When analyzing this legacy, one has to go back to the period when the economies of Central and Eastern Europe were still centrally planned. Then, ideally, money was important only as a medium of exchange, not as an asset. The classic monobank of the old system financed enterprises so that they could pay for the variable costs of production such as labor. These funds were paid back by the receipts from sales. For households, financial or real assets, except for durable consumer goods, were of no importance. They received the wages and spent them on consumption. Investment was financed through special channels.

However, as is well known, huge imbalances occurred in this system, especially in the 1980s. To put it simply, on the one hand unsold inventories were accumulated, and on the other, a monetary overhang came into existence. When the reform programs were launched and a two-tier banking system was set up, these imbalances were taken over. The newly established commercial banks started to act as financial intermediaries, receiving the monetary overhang as deposits and inheriting the loans that had been made to state-owned enterprises. In an economic sense, unsold inventories served as collateral for the loans. As the issue of the creditworthiness of debtors did not play a role at the beginning of the reform process, the unsoundness of the financial system could be dealt with later.

There are several ways of making the system sound again. The first option is to inflate away or to (partially) confiscate the deposits. The use of inflation as a means of getting rid of financial burdens can be witnessed in many countries, but this approach is, of course, inconsistent with the effort to achieve macrostability. The confiscation of deposits was introduced, in Germany and Austria, for example, after 1945, along with currency reforms. Under the second option, deposits are preserved. Then the cancellation of bad debts has to be accompanied by a recapitalization of banks (in one or in several steps), or banks are allowed to dump these debts onto some other agency, such as a state agency. The latter approach is used in the Czech Republic.

One has to be very careful about the allocation and distribution effects that these different options entail. It is especially important to assess whether firms or households, producers or consumers, carry the burden of financial reform. In Germany and Austria after 1945, firms and banks could get rid of their liabilities, and it was the household sector that lost most of its assets. Obviously, it was of interest that firms quickly started investing and producing again; the economic loss for the households was not politically challenging.

In Central and Eastern Europe, things developed differently. For various reasons, the reforms tried to link deposits with positive real rates of interest and to make them convertible. The deposits were only partially reduced by higher prices. This decision put much pressure on the financial sector, using the liability side of the balance sheets of banks as a disciplinary device for the whole system. Disciplining the banks should ultimately discipline the indebted firms. The reform scheme of rewarding the households and disciplining the firms was, in addition, timely from a political point of view.

The basic problem with this approach, however, is that there is a conflict between granting interest-bearing, convertible deposits to households and the priority of a government keeping technically insolvent enterprises afloat. In addition, one can argue that the existence of these deposits is only an economic illusion, as they have to be taxed away or will be lost when firms go bankrupt or have their debts canceled.

My second point refers to the role that universal banks may play within the financial sector when the economies of Central and Eastern Europe are being reformed. Some recent literature1 stresses that the issue of whether banks or capital markets should provide finance to industry deserves systematic analysis, since institutional differences between financial systems may explain some of the variation between U.S., British, German, and Japanese growth patterns.

On a theoretical level (see Hellwig, 1991), what seems to be important is the interpretation of financial intermediation by a universal bank as delegated monitoring within a contractual relationship, thereby allowing firms to lengthen their investment horizon. For example, as reported by Hellwig, page 47, von Thadden demonstrates in a two-period model with “good” and “bad” types of firms, in which the long-term strategy has relatively low expected returns in the first period but relatively high returns in the second, that without monitoring, banks may see low first-period returns as proof of a “bad” firm, and hence discontinue financing: “Anticipation of such behavior induces firms to opt for the short-term investment strategy even though the long-term strategy may eventually be more profitable.” Monitoring a firm, with close links between banks and industry, may avert this problem by shortening the investment horizon, since banks receive additional information about what is “good” and what is “bad.”

Of course, the German or Japanese kind of linkage between universal banks and industry does not create only benefits. Close links between bank and industry managers may, for example, create insider systems, in which the method of self-monitoring no longer works. In addition, a cartelization of banks and industry may occur, thus making the bank-oriented economies less efficient than the market-driven ones.

Why may universal banks be of interest for Central and Eastern Europe? Besides the economic arguments developed in Hellwig (1991), my basic point is a sociological one. In most of the countries of this region (but also in many others of continental Europe), there is either no or only a short tradition of allocating resources via markets. Instead, there were hierarchical, bureaucratic societies. As a result, the marketization of the economy cannot be achieved just by promulgating new laws but has to be seen within the context of democratizing the society and the effective building up of appropriate institutions. Hence, until these institutions are established, insider systems, representing close bank-industry linkages, may serve as excellent monitors of the economy, which may be more effective than any monitoring by anonymous, barely organized markets. If monopoly rents exist as a result of a cartelization of the economy, these rents can be used as shock absorbers. Of course, insider systems need outside disciplining, but this can be achieved by opening up the economy and by making it sufficiently export oriented. This export orientation seems to have helped the German and Japanese economies to become highly productive after the war.

This consideration of the role of universal banks leads me to a final comment on a specific issue raised by Steven Fries and Timothy Lane. They suggest that a centralized workout agency would have greater authority and leverage than a diverse group of banks in restructuring state enterprises. In their paper, this centralized agency somehow appears as a “deus ex machina,” solving all relevant problems. In contrast, as I have tried to outline above, I see a more positive role for banks in this business of restructuring enterprises.

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1This is a revised version of the paper that was prepared for the conference. The authors thank Georg Winckler, the discussant, and other conference participants for helpful comments on the earlier draft. The views expressed are those of the authors, and do not necessarily represent those of the International Monetary Fund.
2The “pocket banks” in the former Soviet Union, which were established largely to channel funds—usually central bank credit—to particular state enterprises are an extreme example.
3Also, in some countries, such as Poland, official policy sanctioned interest capitalization.
4In some cases—notably Poland in 1990—rapid inflation early in the reform programs boosted the profitability of SOEs, as they earned profits on inventories and foreign currency deposits, and as real (product) wages fell owing to the incomes policy. These profits were subsequently reversed, however. See Lane (1991).
5Hughes and Hare (1991) estimate that between one-fourth and one-third of SOEs in Bulgaria, the former Czechoslovakia, Hungary, and Poland were producing negative value added at world prices.
6The diversion of credit for personal use was not limited to SOEs, as Poland’s 1991 Art B scandal demonstrates (Folkerts-Landau, Garber, and Lane, Chap. 5 of this volume). This scandal is a reminder that in addition to the incentive problems of SOEs, there is the danger of outright fraud, which existing supervisory structures may be inadequate to prevent.
7For instance, Hungary introduced a personal income tax and value-added tax in 1988, whereas Poland and the former Czechoslovakia introduced value-added taxes in 1993. In each case, administrative and other start-up costs were substantial.
8A variant of this approach has been used in the United States and in some Nordic countries, where separately capitalized entities have been established to dispose of banks’ problem loans.
9This empirical regularity suggests that there may be some economies of scale in undertaking bad loan resolutions, but the precise source of these gains is difficult to pinpoint (for example, administrative cost savings or greater control over the disposition of assets).
10A combination of inflation and wide interest rate margins increased banks’ net worth dramatically in Poland in the early 1990s, although this solution was temporary and probably unintended. See Lane (1991).
11Another objective is imposition of market discipline (see below).
12This result contrasts with the prevalent notion in the economics literature that a firm with negative net assets should be closed immediately. However, the option to put the assets of the firm onto its creditors associated with limited liability of shareholders can at least in part compensate them for the negative net assets of their firm. See Fries, Miller, and Perraudin (1993).
13The vast majority of the liquidations are thought to involve small firms, but precise data are not available.
14An important lesson to be learned from the experience with privatization in industrial countries is that pro-competitive restructurings should precede privatization. See Vickers and Yarrow (1988). Moreover, Kornai (1990) cautions against pseudo reforms that do not fundamentally alter the organization and conduct of the enterprise sector.
15Uncertainty about ownership claims in emerging market economies has made it difficult to offer property as collateral.
16The Treuhand estimates that about 70 percent of the old debts will be written off.
17In contrast, enterprise restructuring and privatization is proceeding most rapidly in the construction, services, and distribution sectors.
18Burda (1991) examines the extent to which the private sector can absorb displaced workers in the former Czechoslovakia and east Germany.
19Carlin and Mayer (1992) discuss the Treuhand’s role in compensating for the lack of effective governance of enterprises.
20The retention of equity claims on the SOEs would also provide the government with a source of revenue. See Blanchard and others (1991) and Borensztein and Kumar (1991).
1Martin Hellwig, “Banking, Financial Intermediation, and Corporate Finance,” in European Financial Integration, ed.by Alberto Giovannini and Colin Mayer (Cambridge, England: Cambridge University Press, 1991), pp. 35-63; and Colin Mayer, “New Issues in Corporate Finance,” European Economic Review, Vol. 32 (June 1988), pp. 1167-83.

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