1 Introduction

Timothy Lane, D. Folkerts-Landau, and Gerard Caprio
Published Date:
June 1994
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Gerard Caprio,, David Folkerts-Landau, and Timothy D. Lane 

Building a sound, efficient financial system is at the heart of the transformation from central planning to a market economy. The vital function that the financial system performs in a market economy in allocating resources over time is well recognized. Perhaps even more important is the financial system’s role in coordinating economic activity: the cost of finance and its availability for a particular use is fundamental in determining which productive investments are undertaken. Financial discipline—the condition that debts incurred must eventually be repaid—is essential in ensuring that investments undertaken are socially efficient. At the same time, control through the financial system permits decentralization in decision making—the hallmark of a market economy: provided that some entrepreneur or group of investors is prepared to assume the risks of undertaking a project with borrowed funds and that some lender believes that the loan will be repaid, the project can go ahead.

In the world of central planning, finance plays a passive recordkeeping role, while the allocation of resources is controlled mainly by the central plan itself. In this environment of soft budget constraints, the solvency of participants is irrelevant to lending decisions: the criterion under which credit is granted is that the activity for which the funds are needed must be stipulated in the plan. With the abolition of central planning, a coordination vacuum emerges. To fill this vacuum, it is necessary that the conditions be established under which lending is rationed by price and constrained by borrowers’ solvency—that is, that there be sound, market-based finance.

Building sound finance in emerging market economies requires more than observing and imitating the institutions of mature market economies. There are at least four additional considerations that justify further investigation. First, there is the need to come to grips with the legacy of central planning—and, to a certain extent, of the sojourn in the no-man’s land between plan and market. In many countries, a sizable portion of enterprises and financial institutions are already insolvent, owing to the debts accumulated not only under central planning but also in most cases in the succeeding period of output collapse. This legacy implies that suddenly imposing hard budget constraints on all agents is an unworkable solution—and indeed is unlikely to be tried—because of the immediate, widespread, and largely arbitrary bankruptcies that would result.

A second consideration is that finance may play a critical role in transforming the economy itself, as distinct from serving a working market economy. In particular, finance is—or can be—crucial in facilitating the transfer of ownership from state to private sector, and in determining what kind of structure to establish to ensure that privatization results in genuine changes in the way enterprises are run.

A third issue is that formerly centrally planned economies typically face more severe constraints than do mature market economies: given their limited financial and human resources, they cannot incorporate every detail of a sophisticated financial system.1 This makes it important not to import institutions wholesale but to assess carefully which features of the financial system are basic and which are secondary—and particularly, which features depend on the pre-existence of other institutions. For example, establishing sophisticated money and securities markets may depend on the pre-existence of efficient banks—in which case the latter should be given priority and the others left until later. Most would agree that one should resist the dazzle of high-tech finance and concentrate on the basics, but there is room for disagreement on which features are indeed basic.

A final problem is that the financial systems prevalent in advanced market economies are by no means all alike, and so there continues to be debate on which version should be emulated. Discussions in the context of emerging market economies have brought to the fore the differences between various systems—and in particular, advice from Anglo-Saxon countries tends to be different from that coming from either Continental Europe or Japan. It is important to assess which features of these alternative capitalist systems would be useful for formerly centrally planned economies and which might be less appropriate.

These are some of the issues that have guided research and discussion of financial sector reforms in emerging market economies. These themes also run through the papers collected in this volume. The papers are the proceedings of a conference sponsored by the IMF and the World Bank held at IMF headquarters on June 10–11, 1993. Participants included staff members of these two sponsoring institutions, as well as academic experts and policymakers both from formerly centrally planned economies and from developed market economies. The participants were chosen to give a wide range of insights into the issues involved in building a financial structure suitable for economies in transition.

The papers were organized around four main topics. The first is the problem of old and new debts—not only how best to clear up bad debts but how to ensure that new debt is properly priced. The second is the development of a sound and efficient payment system, particularly with regard to how to limit the associated credit risks. The third is the development of an appropriate financial structure—including the respective roles of banks and other financial institutions in the financial system, the problems of supervision and regulation, and the issues involved in bank privatization. The fourth is the importance of credit in the development of the real economy. In the remainder of this overview paper, each of these topics will be discussed briefly.

Old and New Debts

Establishing a sound financial structure in emerging market economies typically means trying to enforce financial discipline in the face of widespread insolvency. Enterprises had often accumulated large debts under central planning, which turned into bad debts for reasons that are mentioned in the paper by Steven Fries and Timothy Lane, and elaborated in Georg Winckler’s comments. In most cases the debts have been substantially augmented during the transition. There have been proposals for a general write-off or socialization of debts—a solution that recommends itself because these debts are to a certain extent an artifact of the old order and do not convey much information about the potential profitability of the enterprises.2 The issue is less clear cut for debts incurred—and still being incurred—after the demise of central planning as a result of the supply and demand shocks associated with transition, the enterprises’ inexperience in dealing with a market economy, and the heightened incentive to borrow associated with negative real interest rates. In addition, the increased autonomy of state enterprises without effective enterprise governance, which gave enterprise insiders (such as workers and managers) scope to appropriate its resources at the creditors’ expense, can contribute to a debt buildup.

The case for a sweeping solution to the debt problem, such as a general cancellation of old debts, is based on the desirability of avoiding widespread bankruptcies while avoiding the moral hazard problems associated with banks whose loan portfolios are riddled with bad debt—as well as with enterprises that continue to operate while already insolvent. Although the case for some kind of debt reduction in most countries is persuasive, there are also some disadvantages, as noted in the paper by Fries and Lane. Canceling the debts may itself pose moral hazard problems, either by creating the expectation of a further cancellation, or simply by transferring resources to enterprise insiders who can then appropriate them. Existing debts, provided that they are not too large to service, may play a valuable disciplining role, forcing enterprises to turn over some of their cash flow. This may be a particularly important consideration in economies that are in the early stages of transition, where there may be severe fiscal constraints owing to the loss of tax revenue from state enterprises, the time required to introduce new forms of taxation, and the absence of financial markets that would permit nonmonetary financing of a deficit. These considerations argue for a selective, case-by-case solution to the debt problem.

Important alternative ways of implementing a case-by-case solution exist, however. One form—a centralized debt workout agency—is discussed in the paper by Fries and Lane. A centralized agency like the German Treuhandanstalt could concentrate expertise in dealing with problem loans and make decisions in each case on whether to restructure the debts or liquidate the indebted enterprise. Such an outside body could perhaps cut through the informal networks carried over from the old system that are widely viewed as perpetuating the status quo—making the problem more transparent by reducing banks’ incentives to roll over bad loans to avoid acknowledging them. Such a body could also take into account some of the wider social implications of its decisions.

However, as Georg Winckler points out, it is important not to view a debt workout agency as a “deus ex machina.” A centralized agency also faces important constraints, several of which are mentioned in the Fries and Lane paper. In particular, it would face the same limitations on human resources, the same political pressures to keep permanently loss-making enterprises afloat, and the same budgetary constraints as would the individual creditors. There are also moral hazard problems associated with taking the bad debts off the banks’ books, as argued in the paper by Stefan Kawalec, Slavomir Sikora, and Piotr Rymaszewski, who suggest that removing the problem loans from the banks’ books may make things too easy for them and may inhibit their learning. If banks are to start to behave truly like banks, they have to start developing collection capabilities, and this might be accelerated by having them deal with the problem loans themselves. Such was largely the motivation for the Polish approach to dealing with bad debts, which, as detailed by Kawalec, Sikora, and Rymaszewski, involves the banks heavily in the workout process. Banks are to establish workout departments, and are given a range of options for dealing with the bad debts, including debt restructuring or write-downs, debt-equity swaps, liquidation, or sale of the loan on the open market.3 The choice between the two solutions depends mainly on a judgment of which type of institution—a centralized agency or the individual bank—is more likely to be able to resist the political and insider pressure against needed restructurings and, where appropriate, liquidations, and which is more likely to be able to assemble the needed expertise to assess the prospects of companies that on paper are insolvent. This judgment would no doubt depend on the political, legal, and institutional environment of the country in which it is implemented.

One form of existing debt that has attracted particular attention is the explosion of interenterprise arrears, notably in Russia in 1992. These arrears were to a certain extent a voluntary phenomenon, disintermediation associated with a tightening of banking sector credit, as argued both in the paper by Barry Ickes and Randi Ryterman and in comments by Jacek Rostowski. Ickes and Ryterman note the particular prevalence of interenterprise arrears within groups of companies that are well aware of one another’s activities. One may interpret this, as the authors do, as reflecting the efficient use of information about the creditworthiness of companies with which a firm has direct dealings; alternatively, it may be viewed as mutual assistance within the insider networks carried over from the old regime—with a government bailout at the end of the road. In particular, even if interenterprise arrears had a negative nominal expected return, enterprises producing inputs for which their customers could not pay may have believed it to be more advantageous to ship the goods anyway and hope to collect later through a clearing of arrears rather than facing the disruption associated with stopping production. The existence of large stocks of interenterprise credit may complicate the establishment of financial discipline, as pointed out by Rostowski, to the extent that companies may claim (possibly with some justification) that they are unable to pay owing to arrears in their payments receivable from other companies. It may also make it more difficult to resolve the bad loan problem, possibly requiring a multilateral approach that goes beyond the workout of bank loans.

Along with resolving the bad loan problem, it is important to maintain financial discipline during the transition. Here, Ickes and Ryterman discuss a controversial proposal made by Ronald McKinnon. Sorting enterprises into two categories, the first are given decision-making autonomy but are required to self-finance, and the second are kept under tight central control and kept afloat with credit. Ickes and Ryterman argue that the cash flow constraint that this would impose on the liberalized enterprises would be unduly severe, particularly given the uncertainties about the timing of receipts that result from the insufficiently developed payment systems in these countries. In the same vein, Fries and Lane emphasize the need for providing financing for the restructuring of enterprises, which typically requires investments that would yield returns in the future. If restructuring is to be guided by market incentives, it would be desirable to provide financing for privately owned firms, if this is compatible with a prudent assessment of risk by lending institutions. Fries and Lane accordingly suggest various expedients for easing the credit constraints—such as equipment leasing and bank financing for the purchase of shares in privatized firms. Such arrangements would facilitate the transfer of ownership and control into private hands, despite the limited wealth of the population, and would help finance the needed restructuring.

Sound and Efficient Payment Systems

A payment system is the arrangement through which “good funds”—the items generally acceptable as final settlement for transactions—are delivered to sellers of goods, services, or assets. Almost universally, these acceptable items are limited to currency, deposits at the central bank, or deposits of other banks. The scarcity of these media, when combined with an inappropriately designed payment mechanism, can slow the tempo of transactions. On the other hand, a payment system can encourage a larger flow of payments by allowing participants to use credit to settle their transactions, thereby imposing excessive credit risk on the system.

The design of a payment system always involves some compromise between the goal of maximum speed and volume in settling payment orders and that of controlling the usual moral hazard problems by limiting the credit provided through the payment mechanism. This tension is inevitable and is resolved in industrial countries in different ways: some insist on a tight limitation of credit risk on the payment system whereas others provide large amounts of credit to generate maximum flows. The choice of the best combination on the payments volume-credit risk frontier has depended on the demands made by the financial system of the individual economies, but most industrial countries are now moving toward limiting credit risk on their payment systems.

The two papers presented in the session on the payment system by Summers and by Folkerts-Landau, Garber, and Lane both describe in detail the principles and technical factors surrounding the proper operation of a payment system. These considerations include the distinction between clearing and settlement and the nature of finality of payments; the trade-off between gross settlement and net settlement; the operations of a clearinghouse; the relationship between the nature of the payment system and the institutions in the money markets; the need for clarification of the legal status of payment media; and the nature of the communication and transportation system for bank advices and documents. The discussions of these issues in both papers can best be described as a characterization of the parameters that establish the position of a country’s payment system on the payments volume-credit risk frontier.

Both papers further apply the principles of sound operation of a payment system to an analysis of the institutions of the economies in transition. Specifically, Summers considers the problems of the Russian payment system, while Folkerts-Landau, Garber, and Lane concentrate on similar issues in the East European context, notably the Polish case. In both Russia and Eastern Europe, the payment system problems are almost identical, except that Russia has the added problem of clearing and settling cross-border payments with the other countries of the ruble zone.

The countries in transition to market economies have inherited payment systems with the drawback both of permitting excessive credit to participants and hindering the flow of transactions. In the monobank systems that predominated under the communist regimes, the making of payments to suppliers took on primarily a financial accounting role and was not a means of disciplining the actions of the participants in the payment system. Credit in the form of float or explicit loans was freely granted by the monobanks to enterprise payors that were short of funds, and all payments were guaranteed. In this environment, because speed of settlement was not an issue, the infrastructure of clearing and settlement of payments remained primitive. Payment orders and checks can still take weeks to settle, so credit must inevitably be granted to payees to cover imbalances, which can create either credit or debit float. But because payment is not certain, lack of sufficiently fast settlement may constrain transactions, forcing many of them onto a purely cash basis.

As the payment systems of the economies in transition are generally inefficient, some reform proposals would permit a greater volume and speed of payments without compromising the soundness of the system. For example, Summers suggests creating availability schedules for funds depending on typical clearing patterns across cities to avoid large fluctuations in float. Both papers recommend that a banking firm should have a single, consolidated account at the central bank rather than individual accounts for each branch. Banking firms would then be much less likely to run payment imbalances at the central bank, and accounting could be decentralized from the books of the central bank to those of the banking firm. Similarly, both papers recommend technical improvements in the communications and transportation systems used by the banks to process payment orders; and Summers recommends changes in the legal system to define clearly the rights and responsibilities of users of checks and to deter counterfeiting.

Other policy proposals encounter the trade-off, alluded to earlier, between the speed and volume of payments and the credit risk to which the system is exposed. Advice on these issues depends on the nature of the financial system that is desired and the authorities’ taste for risk. For example, for large-value interbank payments, the authorities might opt for a gross settlement system—in which each payment order is accompanied by the final settlement medium such as deposits at the central bank. Under gross settlement, no credit is provided directly through the operation of the payment system. Since banks must have a positive deposit in the central bank before the system will process a payment order, banks will have a relatively large demand for reserves. Such a system will restrict payment volumes, especially if there are active financial markets generating wholesale payment flows. Alternatively, the authorities might opt for a net settlement system—in which only the net of all the day’s payments and receipts must be settled at the end of the day. Such a system permits a larger volume of payment orders to be processed with fewer deposits at the central bank. Nevertheless, this gain is provided by increasing the credit risk on the system and absorbing the risk of a systemic crisis if one of the participants in the clearing defaults.

In line with developments in industrial country payment systems aimed at eliminating systemic risk, Summers recommends the choice of a gross settlement system for the economies in transition. Folkerts-Landau, Garber, and Lane point out the trade-off inherent in the choice between gross and net settlement and indicate that the choice will depend on the kind of financial system that the authorities ultimately want to develop. Nevertheless, they too warn of the moral hazard that arises if credit is provided on the payment mechanism. This caution is especially applicable in economies in which the solvency of the financial institutions participating in the payment system is chronically in doubt.

Creating a Sound Financial Structure

The next important question is how to structure a sound financial system that could provide firms with the necessary financing while playing a key role in corporate governance. This issue would remain even if all the pre-existing bad debt problems were solved. Some unresolved questions in this area include how much transitional economies should rely on bank versus nonbank financing; how banking can be made safer; whether universal banking is a sensible choice for transitional economies; and whether bank privatization is part of the solution, and if so, when and how should it be accomplished.

McKinnon’s view, noted above, is that bank lending should not be relied on as a source of finance during the transition process, as the riskiness of the environment, the absence of skilled bank supervision (and bankers), and moral hazard problems probably mean that lending will be unprofitable and misguided. Adherents to this school of thought also argue that because of the scale of the privatization effort that will be a key part of the transition process, stimulating the development of capital markets is the first order of business, and that banking is unimportant or irrelevant to transition. They have added fuel to this debate by proposing a technologically sophisticated—and expensive—payment network to facilitate nonbank finance.

In contrast, most of the participants in the session on creating a sound financial structure emphasized the importance of banks in the transition process, though they disagreed about appropriate policies in the financial sector. As Blommestein and Spencer argue, banks are important because they provide short-term working capital and occupy a key position in the payment process. Without the provision of “good funds” from the central bank, as well as commercial banks’ readiness to provide “lender-of-first-resort” funds to other financial institutions, trade in commodities and financial assets will probably be far less than it would be otherwise. Banks also are important because of their role as gatherers of information in an environment that is anything but transparent. Whereas in advanced economies the profusion of information has recently begun to allow the “securitization” of financing formerly conducted through nontradable bank loans, the underdevelopment of information markets—the absence of reliable accounts and of accountants and auditors—as well as the difficulty in enforcing contractual agreements makes securitization a futuristic solution to finance in emerging market economies.

A principal point of contention for those concerned with putting the banking sector on a sound footing is restructuring of banks. Many observers, including Blommestein and Spencer, recognize that banks are important and that when they are allowed to operate with negative net worth the likelihood of suboptimal decisions emerges. However, a marked divergence of views from that point emerges. Blommestein and Spencer make the case that banks must be restructured early in the transition process, whereas others argue that restructuring should be delayed until the conditions are in place to ensure that they will not be rapidly decapitalized again.4

One way to sort through these issues is to focus on the condition of the banking sector on the eve of reform and what is being asked of it in transitional economies. As is commonly recognized, financial intermediaries mobilize savings, make payments and facilitate transactions, select firms to finance, monitor firm managers and provide some form of corporate governance, and facilitate risk management. Before the onset of the transition process, so-called banks in the economies in transition did not perform these functions but rather passively fulfilled the goals and directives of the planning ministry.5 Often one large savings bank charged with mobilizing resources transferred the funds to the central bank, which then allocated them among the few specialized lending banks. Lending banks in turn did little to screen firms or to monitor their loans, as the risk was born by the government, which regularly reimbursed the banks for any losses. Other financial products and services designed to reduce or trade risk were largely absent, except for some insurance of commercial risks for trade-related industries.

Given this base, what are banks in transitional economies being asked to do? Economies in transition by definition have small but growing private sectors and large and shrinking state-owned enterprise (SOE) sectors. However, in most cases the private economy does not appear instantaneously but rather emerges over time, while the SOEs show no signs of disappearing. An important job for the financial system, in addition to mobilizing resources and facilitating payments, is to allocate resources between these two disparate parts of the economy. A quick and complete restructuring of the banking system might then not be needed and might not stand any chance of success, unless and until the nonfinancial sector was being immediately restructured and privatized as well. If the private sector is to remain small for a while, the urgency for bank restructuring and privatization appears to diminish. Moreover, in most economies new, small firms do not get bank finance but rather resort to self-finance until, having reached a more moderate size, they have achieved a track record and have accumulated some collateral.

One could envisage that the needs of the newly emerging private sector would be served by new (private) banks, including foreign and joint venture efforts, with perhaps some parts of the former state banking sector being split off and privatized also. The state-owned banking sector that remains—not a banking sector as is known in market economies, but more of a “hospital” or restructuring arm of the government budget—would be charged with carrying out the government’s wishes for the SOE sector. An important job would then be to ensure that the share of credit going to the SOE sector declined over time.

The notion that the entire state-owned banking system cannot be “fixed” overnight is also featured in the paper by Millard Long and Samuel Talley. This paper recommends that a special license, of International Standard Bank (ISB), should be awarded to a handful of banks meeting rigorous criteria. This controversial proposal, designed for Russia, is intended to apply to a situation in which there has been essentially free entry. Its goal is to create a number of “good” banks that would ultimately become the core of the future Russian banking system. The plan would operate by offering banks a combination of carrots—allowing them to advertise their special license, borrowing at a lower rate from the discount window, perhaps lower deposit insurance premiums and easier approval of branch applications—and sticks—higher initial capital, meeting the Basle capital adequacy guidelines, an annual audit by qualified firms, adequate loan loss reserves, and tight limits on single borrower exposures.

One critique of the plan argues that it is a good idea that does not go far enough. Although an 8 percent risk-adjusted capital adequacy ratio might be appropriate for well-diversified and macro-economically stable countries of the Organization for Economic Cooperation and Development (OECD), recent debate suggests that regulators believe that it may not be high enough even in the OECD context. The same ratio may be dangerously low when applied to economies in transition.6 Although it is difficult to find historical examples similar to the transition process, it is useful to recall that in the nineteenth century, capital/asset ratios in U.S. and German banks were often 25 percent and higher.7 One might well ask whether it can be convincingly argued that today’s emerging market economies are any less risky than the U.S. and German economies during their industrialization effort. This critique would then imply that if the ISB approach is adopted, extremely high capital ratios must be imposed.

A second critique, offered by Garber, Lindgren, and Schiffman, asserts that the plan is impractical and perhaps even misguided. Regarding practicality, they maintain that because the supply of qualified supervisors is insufficient, a significant lag in verifying ISBs’ compliance with the requirements would occur, and they doubt that even sincere bankers could comply with the commitments that they would be required to make. On a more fundamental level, these critics are concerned that the formation of ISBs could prompt a run on the non-ISBs, and that it is detrimental to give preferential treatment to one class of institution. Raising the capital requirements substantially above those required by the Basle committee would answer some of these critiques—it would certainly reduce the number of institutions needing supervision. Still, it is not possible to dismiss these concerns, as they are legitimate issues, particularly about the phasing in of such a system.

A policymaker might be inclined to ask what are the alternatives in a truly “wild west” banking environment. One response might be to let the “market” work, that is, to allow depositors to lose their funds and thus serve as monitors of the banking system. This laissez-faire view presumes that depositors can monitor banks, which are inherently nontransparent institutions, and that it is practical to deny at least partial deposit insurance to economies in transition.8 Officials might well reason that passing on large losses to depositors would evoke calls to halt or reverse the reform process. If neither of these presumptions holds, some method for selectively limiting entry and increasing the franchise value of bank licenses will help to improve the incentives facing bankers and induce them to invest in making their institution safe and sound.

Another important issue for policymakers is the activities that banks should be allowed to undertake. Many of the economies in transition—in particular those in Eastern Europe and Central Asia—are attracted by the German model of universal banking and have granted universal banking powers to the banks. David Scott advocates delaying the emergence of such institutions until both banking and supervisory skills are sufficiently developed. Nonbanks—institutions not funded by deposits—could provide the skills to help with the restructuring process and with equity finance. In effect, as noted by George Kaufman, this model is the U.S. banking system of the 1940s to the 1970s, and he basically argues that it is appropriate for economies in transition if one deals satisfactorily with the deposit insurance issue.9

Some might argue that whereas the bankers in economies in transition may not be the best finance professionals imaginable, they are the only ones around. Given the paucity of financial expertise in these economies, the banks might be the best hope for exerting rational corporate governance and should accordingly be allowed to take an equity position in enterprises. Scott does not contradict this, but nonetheless suggests that banks should be prohibited from underwriting, trading, or distributing corporate debt or equity securities.

Although disagreement on the limits that should be placed on banks’ powers abounds, perhaps the most convincing compromise was offered by Winckler, who noted that nations’ position in this debate depends on how they view the trade-offs between transparency, economies of scale and scope, and concentration in finance. Outsiders may have little to contribute to the debate other than to note that the trade-offs exist and how to cope with the choices.

Less controversial is the argument that a market-oriented financial system needs private banks at the heart of the banking system and that therefore at some point some parts of the state-owned banking system will need to be sold off. Unfortunately, few countries have much experience with bank privatization, but Guillermo Barnes was able succinctly to recount some of the very practical lessons of greatest interest to the authorities in formerly centrally planned economies. In addition to presenting the mechanics of the process, he argued that authorities should start with small banks, as officials learn much in the process and will thereby make fewer costly mistakes. They can also establish a track record for honesty and transparency that will have positive externalities for other parts of their program. He also asserted the need to build up the supervisory system so that it will be ready for a large private banking sector. On economic grounds, the authorities in economies in transition do not have to privatize their banks within the short time span (13 months) observed in Mexico, but there is no substitute for getting started. As argued above, this may initially involve selling off only small parts of the state-owned banking system, relying on new entrants to fill out the remainder of the private banking group.

The Provision of Credit

Many of the papers in this volume have illustrated, in various applications, the role of financial discipline in guiding the allocation of resources during and after the transition to a market economy. But some observers have sounded a cautionary note, in the context of the output declines that occurred in Central and East European countries in the early 1990s. Guillermo Calvo and Fabrizio Coricelli argue that if financial discipline is imposed too early, severe macroeconomic consequences may result. In their interpretation, an important ingredient of the output decline was that central banks indicated that they would no longer be willing to provide unlimited and automatic credit. This change in the role of the central bank led to a vacuum in credit markets that could not immediately be filled, given the absence of the information, trust, rules, and institutions needed to enable a private credit market to function. No private mechanism was immediately available to offset the decline in the stock of credit associated with the price jumps that followed price liberalization at the onset of the reform programs.

Calvo and Coricelli focus on enterprises’ response to a reduction in liquidity, which they associate with credit. They assume that enterprises face a liquidity-in-advance constraint, requiring liquidity in proportion to output. Prices are assumed to increase exogenously, while the nominal quantity of liquidity or credit is limited, leading to an output collapse. The liquidity crunch may to some extent be offset through lower wages, with the firm in effect borrowing from its workers.10 However, assuming that there is some floor to wages, or that for some other reason workers are unwilling to lend enough to the firm, output will nonetheless decline. An expansion of interenterprise arrears would partly offset the effects of the credit contraction, but the imperfection of private enforcement mechanisms may limit the scope for interenterprise arrears without a government guarantee.

The analysis of Calvo and Coricelli focuses mainly on the macroeconomic aspects of credit provision as an explanation of output decline. In addition to the aggregate decline in real credit the authors discuss, the distribution of credit among firms may also have played a role in the output decline.11 More generally, their argument points to the difficulty of establishing working credit markets in economies in transition and its importance for economic activity. However, the quantity of output is not the only criterion by which economic policy should be judged, and even if one accepts the view that a credit crunch was responsible for the output decline, this has to be weighed against the view, discussed earlier, that financial discipline may influence significantly the composition and efficiency of production. Moreover, as the authors acknowledge, macroeconomic solutions to a liquidity crunch may not work: for instance, increasing the nominal quantity of credit may undermine the disinflation effort and thus further decrease the real quantity of credit. This leaves the policymaker with a dilemma: how to impose financial discipline without drying up the credit that is needed to finance economic activity.

In China, not only does finance appear initially to have played a lagging role, but it also has presented quite the opposite case from the Calvo-Coricelli credit crunch. The Chinese reform strategy, implicitly or explicitly, has featured a reliance on nonstate firms as the engines of growth. As with virtually all young firms in any economy, these nonstate enterprises have relied heavily on self-finance, with workers and township and village residents taking equity in their firms. A high initial savings rate helped fuel this process. The Chinese financial sector benefited substantially from relatively little financial repression: except for a brief inflation spike, real interest rates on deposits have remained positive or zero since 1980. This absence of significant repression probably contributed to the high savings rate, which has underwritten the self-finance boomlet. In addition, China has benefited from a large amount of foreign direct investment, which has financed investment especially along the southeast coast. Shahid Yusuf also argues that recently some signs indicate that bank financing is on the rise, as might be expected as firms mature and become more established.

China has not yet experienced the credit crunch discussed by Calvo-Coricelli; both the high savings rate and capital controls make it easier for many demands for investment to be satisfied. However, as investment demand rises in the nonstate sector, and as it becomes necessary to rein in monetary growth to check inflationary pressures, conflict between the state and nonstate sectors may well arise, rendering some type of crunch more likely. However, the main problem that the central bank will face will be reining in the expansion when a significant amount of liquidity exists in the system. This can become an important issue in transitional economies where many of the tools of monetary policy are lacking. A resort to direct controls, while effective in the short run, risks being so blunt as to reduce growth sharply, though, to be sure, a continuation of accelerating inflation would damage the real economy even more.


Many of the issues raised above underline what has been learned in developing countries, namely, that financial reform is a process, not an event. It is a process because it takes time to build skills and institutions and to change incentives. And financial systems do not function in a vacuum, but rather depend heavily on, and in large part reflect, the nonfinancial sector. Since the latter’s transformation takes more time than was thought at the start of the transition process, it is not surprising that financial reform is slow going.

Nonetheless, efficient financial intermediation will make an important contribution to improving the allocation of resources which, after all, is the goal of the transition process. It is to be hoped that the lessons and discussion set out by this conference and others like it will accelerate the transition process and help to build sound financial systems in transitional economies.


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Here, as in many areas, the exception that proves the rule is east Germany, which because of its own particular circumstances has adopted an existing system lock, stock, and barrel.


Debt socialization implies that the debts are no longer the liability of the enterprise but of the state itself. See Calvo and Frenkel (1991).


The latter solution appears to entail a “market for lemons” problem, since the banks would presumably sell the loans that, based on their own information, they believe are worth no more than the price offered—which in turn must be low enough to reflect buyers’ low valuation of the loans that the banks are prepared to offer for sale.


See Levine and Scott (1993) and Caprio and Levine (1994) for a discussion of when to restructure banks. In many regions, including Eastern Europe, bank restructuring without more fundamental reforms—including improving supervision and regulation, raising capital requirements, and training bankers—has proved to be short-lived; some restructured banks and banking systems have lost their new capital in short order. This argument is not against recapitalization, but it does suggest that it should occur later in the reform process.


The degree of passivity undoubtedly varied, but the only country in the second half of the 1980s to which this generalization does some injustice is Hungary, where the transition process commenced earlier in the decade.


Another suggestion that the 8 percent standard is too low even in OECD countries is the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) in the United States, which accords wide powers to banks satisfying a 10 percent risk-adjusted capital ratio, with limitations on powers increasing as capital falls from this level.


See Tilly (1966) (for Germany) and Hammond (1957) (for the United States).


See Caprio and Summers (1994) for a discussion.


Given the underdeveloped banking and supervisory skills, Kaufman’s views on structuring capital requirements and deposit insurance to allow supervisors sufficient time to intervene before bank capital is exhausted are quite consistent with the remarks above on the desirability of a high capital ratio.


They assume that firms do not have access to international capital markets but that workers do.


See the comment by Rudiger Dornbusch.

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