The Determinants of Borrowing in the Case of the Newly Exchange-Listed Firms in Romania: When Budget Constraints and Adverse Selection meet Cronyism Calin Valsan Associate Professor of Finance Williams School of Business and Economics Bishop’s University Lennoxville, Quebec, J1M 1R1 (819) /2448

Objective Re-evaluate: Budget constraints Determinants of corporate borrowing

Background Communism collapsed in December 1989 Issues of transition: Price liberalization Price stability Budget constraints & market discipline Privatization Foreign investment EU enlargement

More background… For the better part of the 1990s, the government was not able to impose enduring financial discipline. Contributing factors: The massive “capital restitution” of the early 1990 Fear of popular backlash The implicit bailout clause [Colombo (2001)] MEBOs [Valsan (1999)]

Previous research: Polish firms Pinto et al. (1993), Pinto and Wijnbergen (1994), and Wijnbergen (1997): Initially negative, the relation between firm profitability and new borrowing appears to be reversing, suggesting that banks decreased lending to distressed firms Bonin and Leven (2000): Banks’ ability to act as a conduit for financial discipline is somewhat limited

Previous research: Romanian firms (i) Perotti and Carare (1996): Observation: A negative correlation between profitability is no proof of poor lending quality: - Leverage is demand driven for good firms and supply driven for financially distressed firms. - Pecking order theories Findings: The correlation between new lending and bank arrears is fading, The correlation between new lending and trade arrears is getting stronger

Previous research: Romanian firms (ii) Carare, Claessens, and Perotti (1999), Djanikov and Ilayperuma (1997) and Djanikov (1999): Focus: Financial isolation program & correlation between new lending and arrears. Findings: (i) The correlation between new loans and arrears is fading (ii) Banks now refinance doubtful receivables and wage arrears. (iii) Firms under financial isolation face softer budget constraints.

Current contribution Re-assess the implementation of financial discipline, focusing on privatized & exchange-listed firms Expand the analysis of borrowing determinants to include other factors, such as financing needs and ownership structure

Data About 580 companies traded on the Bucharest Stock Exchange and RASDAQ between 1997 and (provided by Comisia Nationala a Valorilor Mobiliare)

Table1. Sample statistics MeanMedianMinimumMaximumStandard deviation Total debt ratio199719%11.5%0170%23% %12%0200%24% Total long-term debt ratio %0023%14% %0023%13% Profit margin %-36%41%13% %9.8%-35%38%11.75% Number of employees , , Dividend payout ratio %00100%33% %00100%31% Number of stakeholders per firm

Methodology NEWB=a 0 + a 1 EMPL + a 2 DEF + + a 3 ARR + a 4 PRF + a 5 DUMPAS + a 6 DUMX + Σa i DUMST + e NEWB = new borrowing, EMPL = number of employees, DEF = flow of funds deficit, PRF = the ratio of before interest and tax earnings to net income, ARR = total arrears, DUMPAS = dummy variable equal to one if MEBO, DUMST = dummy variables controlling for the three main economic sectors, DUMX = dummy variable equal to one if stake owned by Romanian nationals.

Definitions: Flow of funds deficit Shyam-Sunder and Myers (1999): DEF = DIV + CAPX + ΔNWC + CRPMT - OCF Where: DEF = funds flow deficit, DIV = dividend payments, CAPX = capital expenditures, ΔNWC = net increase in net working capital, CRPMT = interest payments and redemption of debt, OCF = operating cash flow

Definitions: Arrears ARR = BANKARR + TRADEARR + WAGEARR +TAXARR Where: ARR= total arrears, BANKARR = bank arrears, TRADEARR = inter-company trade arrears, WAGEARR = wage and pension plan contributions arrears, TAXARR = tax arrears, including corporate income tax & VAT.

Table 2. Regression results Total new borrowing (restricted: A) Total new borrowing (restricted: B) Intercept EMPL0.56***0.545***0.563*** DEF-0.432***-0.435***-0.433*** PRF ARR-0.126***-0.127***-0.133*** DUMPAS DUMX0.065**-- SECT SECT ** -0.7** DUMOWNSTR * R2R Adjusted R F-value88.3***113.5***98.48***

Findings (1) The firms in the sample are on average medium sized, with a very concentrated ownership; the typical stake is about 30%-60% of the total number of common shares. (2) The overwhelming majority of these firms are profitable (even before correcting for possible understated profit margins), but pay very little dividend. (3) The overwhelming majority of these firms exhibit very low levels of debt. Most of the debt is represented by short-term loans. (4) New borrowing is inversely related to the need for funds, as measured by the flow of funds deficit. (5) New borrowing is inversely related to all types of arrears; firms falling behind in paying their wages, taxes, payables, or bank debt are less likely to obtain new credit. (6) Firms owned by Romanian nationals and their families are more likely to borrow, while the opposite is true of firms owned by managers and employees (7) Firms in services and transportation are more likely to borrow than firms in agriculture, constructions, and manufacturing.

Table 3. Crosstabs for dichotomous variables: Loan guarantees vs. ownership structure (expected count in brackets) Panel A. Credit guarantees and Romanian nationals Dummy for stakeholder type 1: Romanian national 0: Any other stakeholder Total Dummy for credit guarantee 1: credit guarantee 105 (93.7) 84 (95.3) 189 0: no credit guarantee 68 (79.3) 92 (80.7) 160 Total Pearson Chi-square: 5.9**

Table 3. Crosstabs for dichotomous variables: Loan guarantees vs. ownership structure (expected count in brackets) Dummy for stakeholder type 1: MEBO0: Any other stakeholder Total Dummy for credit guarantee 1: credit guarantee 9 (12) 180 (177) 189 0: no credit guarantee 13 (10) 147 (150) 160 Total Pearson Chi-square: 1.5 Panel B. Credit guarantees and MEBOs

More findings… (8) Loan guarantees/facilities tend to be associated with equity stakes in firms owned by Romanian nationals and their families... …this is not consistent with: - Corporate governance and agency costs [Jensen and Meckling (1976), Jensen (1986), Shleifer and Vishny (1997)]. - Nationalist sentiment hypothesis

Alternative conjecture: Political cronyism The majority of Romanian individual stakeholders are: Political insiders Former administrators Political campaign contributors (1996 elections)

Big picture Two-tier system: State owned corporations: still facing soft budget constraints Privatized & exchange-listed firms: subject to market discipline

EU update Romania’s accession to the EU will not take place before 2007, at the earliest Issues: Fully functioning market economy?