In Discussion Paper No. 1392, Research Fellows Francesca Cornelli and Richard Portes, and Research Associate Mark Schaffer investigate whether the process and institutions of financial intermediation in transition economies are permitting firms to achieve their desired (or optimal) capital structure despite the prevalence of incomplete information in these markets. They construct a theoretical view of the determinants of the firm's optimal capital structure in transition and compare the levels as well as the structure of corporate debt in Central and Eastern Europe to Western companies. Tax shields, which make debt financing advantageous, are found to be relatively high while bankruptcy costs are low in transition economies. Both of these features would give firms an incentive to accumulate a comparatively high degree of indebtedness. Despite this, enterprises in the Czech Republic, Hungary and Poland have relatively low amounts of debt: one possible explanation is the pre-transition system of financing fixed investment through budget grants.

The authors ask whether the low leverage observed in these countries is only a transitory characteristic due to historical circumstances or a persistent feature that should cause concern over the functioning of the financial sector. Two scenarios are empirically tested. First, if financial intermediation is working well, banks will be lending to firms that can signal their quality by using collateral or their profitability. Second, if banks cannot reliably distinguish among firms, there will be credit rationing and firms will use internal forms of financing. The study concludes that there appears to be significant credit rationing, and that firms cannot at present attain their desired capital structures. In transition economies, financial intermediation is still functioning poorly.

The Capital Structure of Firms in Central and Eastern Europe
Francesca Cornelli, Richard Portes and Mark E Schaffer