Eastern Europe
Enterprise debt

Throughout Central and Eastern Europe, enterprise debtors' failure to make scheduled payments of debt is preventing the price mechanism from properly guiding the reallocation of resources; normal market exit is suspended and the disproportionate share of bank credit effectively refinancing incumbents impedes entry. In Discussion Paper No. 695, Research Fellow David Begg and CEPR Director Richard Portes argue that this may be the single greatest obstacle to economic restructuring in the region. Banks' failure to enforce debt contracts with long-standing customers reflects neither the passive adjustment of finance to targets for the real economy as under the previous regime nor a failure of political will or management expertise; there are powerful incentives for banks not to enforce debt contracts. The enactment of bankruptcy laws is not sufficient to initiate bankruptcy proceedings, governments cannot successfully delegate credit allocation or associated control rights over closure, and with major credit market failures, privatization is unlikely to promote substantially greater efficiency.

`Creditor passivity' may arise when the expected value of the debtor's assets is less than the costs of enforcing bankruptcy or because there is an `option value' in waiting to see whether the debtor's fortunes improve. Severely undercapitalized banks with extensive non-performing loans facing political pressures to finance struggling state-owned enterprises (SOEs) may also conclude that their debtors are `too big to fail'. This increases creditor passivity in inter-enterprise credit, which increases uncertainty about the liquidation value of individual firms, adn therefore increases systemic risk and redistributes liquidity away from sound enterprises. But if banks press vigorously for bankruptcy, enterprises will also take a tougher line with their customers; the unusually rapid growth of inter-enterprise credit is a symptom of more fundamental underlying credit problems.

Begg and Portes therefore propose the immediate recapitalization of banks, with government taking over all their non-performing loans and replacing them at par with Treasury bills and keeping loss-making SOEs open only with explicit, cash-limited fiscal subsidies. In a second stage, government holdings of SOEs' debt and the latters' physical assets should be marked to market to prepare for their privatization. Under this reform, banks and SOEs remain within the state sector, so public finances do not deteriorate, but a fiscal problem that is currently concealed is made explicit. From an assessment of the size of this fiscal burden and how it should be interpreted, the authors conclude that the international institutions must put the full weight of their authority and credibility behind such a package in order to break through the obstacles to successful restructuring.

Enterprise Debt and Economic Transformation: Financial Restructuring of the State Sector in Central and Eastern Europe
David Begg and Richard Portes

Discussion Paper No. 695, June 1992 (AM)