SOFT BUDGET CONSTRAINTS SBC

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SOFT BUDGET CONSTRAINTS (SBC) RESTRUCTURING OF
FIRMS IN TRANSITION ECONOMIES
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Introduction

• Production structure was distorted compared to
  market economies
• Relative overdevelopment of heavy (e.g. military)
  industry vs underdevelopment of services
• Biased toward few big firms and against small
  firms
• High capital intensity but obsolete equipment
• Low quality products
• Labour and input hoarding

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Table 1 Sectoral Allocation of Labour in OECD
and CPEs (percentage shares)
Source OECD
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Table 2. Distribution of Employment in Industry
by Size of Firms (Percentage shares)
Source OECD. Data for West Germany, France and
Italy are from 1987, for the GDR from 1988 and
for the other countries from 1989.
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Restructuring

• With transition ?Need change of structure and
  organisation of production plus in most cases
  ownership
• Reduce labour (especially low productivity labour
  and close down obsolete plants
• Change products and product quality
• Change capital equipment
• Change managers
• ? higher output, quality and productivity
• ? also unemployment state sector and potentially
  overall although future recovery

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Initial and Deep Restructuring

• Initial Restructuring
• Shedding off labour that does not directly
  contribute to the production process (social
  networks)
• Wage cuts in order to meet hard budget constraints

• Deep Restructuring
• Adoption of modern technologies
• Re-training of management and workers
• Replacing the inefficient production workers with
  the more efficient ones
• Modernisation of obsolete equipment

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Obstacles to Deep Restructuring

• 1. Those whose jobs are at risk will oppose
  restructuring
• unskilled managers
• workers at obsolete plants
• 2. Restructuring is likely to require large
  financial expenditures
• capital equipment of state firms is obsolete
• financing replacement from retained earnings
  difficult no well-defined rights for future
  profits
• 3. Privatisation mode (e.g.insiders), lobbies,
  political commitment, unemployment compensation

Individuals dont like HBC (hard budget
constraints)
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Soft Budget Constraints(SBC)
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A question for you
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Soft budget constraints

• Definition
• The government cannot commit not to bail out
  loss-making firms.

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SBCs different views

• Paternalistic attitude of the state (Kornai,
  1980)

The state will rescue a failing firm because it
is unwilling to accept the social consequences of
its closure. The SBC was introduced by
Kornai(1980) to explain shortages in socialist
economies with price mechanisms, e.g., the market
socialist system introduced in Hungary in 1968.
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SBCs different views

• Political economy incentives, bargaining between
  enterpreneurs and politicians (Schleifer and
  Vishny, 1994)
• Dynamic commitment problem not to refinance in
  the presence of a sunk investment and in the
  presence of asymmetric information (Dewatripont
  and Maskin, 1995)

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Why are SBCs a problem?

• It may prevent unprofitable firms from
  restructuring the threat of bankruptcy is not
  credible and hence incentives to restructure are
  absent
• SBCs may be an obstacle to the process of sector
  reallocation continued subsidies to loss-making
  firms may prevent private firms from bidding
  efficiently for workers employed in inefficient
  SOEs.
• Macroeconomic stability may be jeopardized
  because government expenditures are not under
  control in the presence of SBCs

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Measures for SBCs

• Net Bank Financing SBCs
• the firm suffers from SBCs if it obtains new
  (bank) loans despite the fact that it is
  loss-making
• Credit Related SBCs
• the firm suffers from SBCs if it is loss-making
  and enjoys more credit days than the average
  profit-making firm receives, reflecting an
  inability to pay.
• Government subsidies and tax arrears

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Budgetary Subsidies in Central and Eastern Europe
(percent of GDP)
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Budgetary Subsidies in CEE - statistical analysis
Two things should be noticed 1)The size of SBC
is rather low in most transition economies, given
that under socialism they were in the 25 percent
range. (IMF-led macro stabilization programs)
2)Subsidies were and are still important in
Russia and Ukraine.

• Subsidies to enterprises are not necessarily a
  measure of SBC.
• Nevertheless, given the past history in
  government-firm relationships, one can presume a
  rather strong correlation between SBC and the
  extent of subsidies.

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Government subsidies and tax arrears

• In the rapidly reforming TEsbudgetary subsidies
  are usually concentrated in a small number of
  sectors that are typically subject to low fixed
  prices.
• The main route by which budget constraints are
  softened in the rapidly reforming TEs, and one of
  the main routes by which they are softened in the
  slower reformers, is via tax arrears.

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Tax arrears definition and forms

• Tax arrears are taxes that have been accrued and
  have come due but have not been paid.
• The tax arrears problem in TE takes two forms
• tax arrears accumulated by distressed firms
• tax arrears as a focus for lobbying by profitable
  firms or firms in general.

SBC
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Tax arrears as SBC

• Why do the tax authorities tolerate the
  accumulation of tax arrears in distressed firms?

So, do firms in transition countries have soft
budget constraints? The evidence is far from
complete, but it seems to be that loss-making
firms in TEs are sometimes able to extract
subsidies and get rescued.
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Paper On the causes of SBCs Firm-level evidence
from Bulgaria and Romania

• Hypotheses that were tested and confirmed
• more competition promotes HBCs
• privatisation makes SBCs less likely to occur
• big firms can be too big to fail and enjoy more
  SBCs in case of difficulties

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Privatization and Restructuring of Firms in
Post-Privatization Period A Lesson Learned
from Slovenia
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The main topic

• ISSUES
• The effects of privatization on firms
  performance.
• Insider vs. outsider owned firms. Which group of
  owners is more efficient?
• The importance of initial conditions and trade
  orientation

The main hypothesis The process of restructuring
of Slovene firms was affected by uderdeveloped
institutional structure.
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Model of Restructuring
INSTITUTIONAL FRAMEWORK
FIRM-LEVEL CHARACTERISTICS
RESTRUCTURING
DEFENSIVE
STRATEGIC
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The evolution of institutional framework
The process of transition in Slovenia

• Evolutionary path characterized by stabilisation
  policy with restrictive monetary and fiscal
  policies
• Floating exchange rate
• Relatively slow process of ownership
  transformation and gradual changes in
  implementing market environment
• Export demand as the most important factor of
  growth

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The evolution of institutional framework, cont.
BUT

• Microeconomic reforms have been proceeding slowly
  impeding corporate restructuring.
• Some of reforms (i.e. on the labor market)
  started yet very late.

The further development of market and
institutional structure represents one of the
most important factors for future growth.
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The Bargaining Over Excessive Cash Flow
Wages
Total revenues -material costs -depreciation -tax
?
Investment
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Empirical specification

• Standard models augmented by
• Internal funds hypothesis
• Bargaining hypothesis
• Ownership structure
• Supervisory board structure
• Privatization method
• Trade orientation
• Industry region

Firm-level characteristics
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Data
SAMPLE 157 Large and Medium-Sized Slovene
Firms In 2000, the average firm in the sample
employ 538 employees, has labor costs that
constitute 85 of value added, achieves a ratio
of sales to tangible capital of 2.8 and sells 58
of its production on domestic market. PERIOD
1996-2000 SOURCE Questionnaires Agency of
Payment
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Data, cont.
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The evolution of the ownership structure
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The evolution of the Supervisory Board structure
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Managerial characteristics
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Fixed and Soft Capital Investment
In of total revenues
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Results

• Investment in fixed capital
• Internal funds have impacts on investment in the
  short run but not on the long run (investment
  opportunities!!!)
• Ownership structure doesnt matter
• No bargaining

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Results, cont.

• Investment in RD
• Internal funds have impacts on investment in the
  short run and on the long run
• 90 of RD financed by internal funds
• Ownership structure matters (are FDI positive for
  RD?)

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Results, cont.

• Investment in marketing
• Internal funds have impacts on investment in the
  short run and on the long run
• Adjust quickly to the desired level
• Bargaining confirmed
• Trade orientation matters

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Results, cont.

• Investment in training
• Does training represent investment or source of
  additional remuneration?

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What has happened with managers?
Reasons for management turnover in the 19982002
period (Knezevic, Domadenik, Prasnikar, 2007)
Source ISEE research (2003) and own calculations.
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Discussion and Implications

• Limited defensive and relatively successful
  strategic restructuring
• Lack of institutional reforms (especially on
  labor and capital markets)
• State should withdraw from economy faster and
  abandon its paternalistic role