Chapter 3 Soft Budget Constraints

A question for you

Soft budget constraints b Definition: The government cannot commit not to bail out loss-making firms.

SBCs: different views b Paternalistic attitude of the state (Kornai, 1980) b Political economy incentives, bargaining between enterpreneurs and politicians (Schleifer and Vishny, 1994) b Dynamic commitment problem not to refinance in the presence of a sunk investment and in the presence of asymmetric information (Dewatripont and Maskin, 1995)

Why are SBCs a problem? b It may prevent unprofitable firms from restructuring: the threat of bankruptcy is not credible and hence incentives to restructure are absent b 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. b Macroeconomic stability may be jeopardized because government expenditures are not under control in the presence of SBCs

How serious is the problem?

Which firms are concerned?

Conclusions b Soft budget constraints persist in several forms: net bank financing, i.e. soft credit conditionsnet bank financing, i.e. soft credit conditions tax arrears (also to social security)tax arrears (also to social security) wage arrearswage arrears trade arrears (e.g. state utility suppliers)trade arrears (e.g. state utility suppliers)

A game theoretical explanation of SBCs b B g, B p > 0 b B l < 0 b R g > 1 b R p + B p < 2 b distribution of good and bad projects in general (  ) is commonly known but the specific project under consideration is only known to the E at first; the G finds out about the project’s type only at the end of period 1 b the G has a ‘broad’ welfare function: it cares about the taxable returns it can appropriate (R i ) and it cares about the welfare of its citizens (B i ) b no pay-offs after 1 period in case the project turns out to be bad

3 questions we need to answer b Is E going to submit/not to submit the good projectthe good project the bad projectthe bad project b Is G going to finance/not to finance remember G doesn’t know whether the project is good or badremember G doesn’t know whether the project is good or bad b Is G going to refinance/liquidate in case the project turns out to be bad

Summarising b The proportion of good projects (  ) has to be sufficiently big for the G to choose to finance whichever project is being presented (good or bad) to it to get funded. b SBCs are expected if R p + B p - 2 > L + B l -1R p + B p - 2 > L + B l -1 bad projects are submitted and are subsequently refinancedbad projects are submitted and are subsequently refinanced this typically holds if L is low (due to capital market imperfections, outdated capital stock, …)this typically holds if L is low (due to capital market imperfections, outdated capital stock, …) b HBCs are expected if R p + B p - 2 < L + B l -1R p + B p - 2 < L + B l -1 bad projects are not submitted, only good projects are submittedbad projects are not submitted, only good projects are submitted HBCs can be promoted through demonopolisation and through privatisationHBCs can be promoted through demonopolisation and through privatisation

Promoting HBCs b Demonopolisation R p (  ) + B p - 2 < L + B l - 1R p (  ) + B p - 2 < L + B l - 1 b Privatisation welfare function of the government becomes less ‘broad’welfare function of the government becomes less ‘broad’ R p & B l 0 & B l < 0)

Paper: On the causes of SBCs: Firm-level evidence from Bulgaria and Romania b Hypotheses that are tested: more competition promotes HBCsmore competition promotes HBCs privatisation makes SBCs less likely to occurprivatisation makes SBCs less likely to occur big firms can be ‘too big to fail’ and enjoy more SBCs in case of difficultiesbig firms can be ‘too big to fail’ and enjoy more SBCs in case of difficulties b Measurement of the variables: concentration ratio within the sector (pos. related to monopol.)concentration ratio within the sector (pos. related to monopol.) import penetration ratio within the sector (pos. related to comp.)import penetration ratio within the sector (pos. related to comp.) firm-level data on ownershipfirm-level data on ownership firm-level data on employmentfirm-level data on employment firm-level data on SBCsfirm-level data on SBCs

2 measures for SBCs b Net Bank Financing SBCs the firm suffers from SBCs if it obtains new (bank) loans despite the fact that it is loss- makingthe firm suffers from SBCs if it obtains new (bank) loans despite the fact that it is loss- making b 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.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.

Empirical work b SBC i,t =  +  1 herf i,t-1 +  2 import i,t-1 +  3 empl i,t +  4 state i,t +  5 foreign i,t +  6 municip i,t +  7 insider +  T t=2 time t +  i +  I,t b i -> large and medium sized manufacturing firms in Bulgaria and Romania b t -> time period b regressions for the entire sample of firms and for firms with negative profits only b * refers to a statistically significant effect

Empirical results b Competition decreases the likelihood for SBCs to be present b Privatisation makes SBCs less likely to occur b Big firms can be ‘too big to fail’ and enjoy SBCs when they are loss-making b Policy implications!