Soft and Hard Budget Constraints - Essay Example

? of Edinburgh School Of Economics Economics of Transition How can rent-seeking activity by banks disrupt the process of hardening budget constraints in the transition economies? 27th March 2012 Table of Contents 1. Introduction 3 2. Soft and Hard Budget constraints 4 3. Rent Seeking 6 4. Lender of the Last Resort 8 5. Conclusion 9 6. References 11 1. Introduction A remodelling of the economic structure during the last century has ensued in substantial transformations in the social and political spheres. In the annals of history, the competition between socialist and capitalist economies will remain as one of the most imperative events that occurred in the twentieth century. This competition not only transformed the contours of politics in the twentieth century but also led to the creation of two parallel and competing economic systems. Transition can be defined as the race of transformation of centrally planned economies into free markets. Such a transformation can be seeing as occurring after the political events that decimated the Soviet Iron Curtain. Transition is characterized by liberalization, macro-economic stabilization, restructuring and privatization and legal and institutional reforms. Countries have employed disparate transition models owing to the distinct initial circumstances that prevailed at the time when transition process materialized. Moreover, transition circumstances can also be seen as the product of the country’s peculiar socio-economic realities. While some countries like China embraced a slow and steady economic transformation approach, others like Russia adopted an aggressive and speedy model. It was envisaged that a swift approach could be undertaken for the privatization of small corporate entities as well as liberalization of prices and macro-economic stabilization, without encountering much economic problems (International Monetary Fund, 2000, p.3). The significance of transition for these economies can be attributed to the fact that any immature measures for transition tend to lead to economic collapse. This was all the more clear for example in the Russian banking sector failure in the late nineties. This paper will analyse how rent-seeking activities of financial institutions can have a bearing on hardening budget constraints in the transitional process. 2. Soft and Hard Budget constraints It was Kornai who invented the term ‘soft budget constraint’ to elucidate economic behaviour of the communist economies. This concept is deemed as the focal point of the subject of transition from socialist to capitalist economies. The term itself is derived from microeconomic terminology to shed light on a pragmatic economic social syndrome. The necessity of implementing hard budget constraints is accentuated repeatedly in relation to transition of socialist economies. The disintegration of the banking sector of East Asian economies during the nineties era can be comprehended by studying soft budget constraints (Kornai et al., 2003, p.54). The soft budget hypothesis denotes a condition under which firms incurring losses are bailed out by banks. Banks can undertake this role in both, capitalist and socialist economies. However, its repercussions in socialism make it a potential problem since banks are compelled by the state to rescue loss-making entities, for safeguarding employment or pursing other aims. The entanglement of state and banking into one entity means that any failure on the part of the banks will reflect clearly in the finances of the state. Typical failure in these circumstances leads to massive cuts in social sector development. Under a soft budget constraint, capital is injected in the loss making firm by the banks to keep them afloat and in a position to pay taxes, therefore acting as a disincentive for privatization. Research on the issue practically proves by applying a model based on the local authorities, a bank and firm (Brandt et al., 2003, p.13). The bank managers’ propensity to lend loans to private firms rather than SOEs will escalate as the former is more likely to be successful; this in turn will encourage privatization by the government. Studies on the issue reveal that allocation of financial resources to SOEs was done better by banks than the government in 1980s (Cull & Xu, 2000, p.28). In the 1990s, on account of inflation, banks were substantially commercialized and the central bank withdrew the lending power from its local branches. Commercial banks were directed to centralize decision-making and four chief commercial banks implemented international standards in 1994 (Cao et al., 1999, p.105). In 1998, a regulation proscribed government guarantees for loans to SOEs and necessitated that minimum of 70 percent of outstanding loan should be backed up by collaterals. Additionally, a new policy ‘life-time responsibility’ was adopted, explicitly stating that an officer will be dismissed if sole loan approved by him results in default. The stringent government regulations acted as a pressure for banks to ensure that loans are adequately utilized and repaid. The results of these measures ensured that the red tapist attitude of banking bureaucracy changed and that the finance doled out by the banking sector was not lost to political gains. Kornai made a similar observation of the soft budget syndrome in the Hungarian economy during the 1970s which was back then transforming from a socialist economy into a free market. Even though, the publicly owned entities were assigned the moral and financial responsibility of profit maximization yet the recurrent loss makers were sustained. This greatly impacted their behaviour since losses posed no threat to their survival. Janos Kornai argued that softness of budget constraint was one of the fundamental underlying reasons of inefficiency of firms gained wide-spread acceptance because of its practicability in real economies (Kornai et al., 2003, p.76). 3. Rent Seeking Apart from solvency, there are can be other grounds for bailing out a bank by the government. Certain quarters advocated that the government will provide subsidies to banks for persuading them to refinance other poor schemes (Berglof, 1995, p.360). This kind of behaviour is an integral element of transitional economies. The logic behind this is that state has a responsibility to the society and thereby it should take ‘external effects’ into account, besides confirmable revenue (Anderson, 1997, p.103) (Perotti, 1993, p.1022). This kind of behaviour on the part of the state ensures that regulation measures are able to achieve the desired aims with little friction being developed in the political processes. Banks can easily take advantage of the softness of the state. They can induce the government to bailouts or in general, indirectly compel them to pay rents. This is because one of the primary macro-economic goals of the government is the welfare of its people by provision of employment and affording a suitable standard of living. On the other hand, banks do not share such aims but are established on the principle of profit maximization; hence their concern only lies with the verifiable revenues. Such games constitute an imperative feature of a transitional economy. Nowadays, it is extremely exceptional for a large bank facing financial crunch to wind up; there is an accelerating trend of take-over of such loss-making banks by more successful banks in operational condition. This softness here is shown by the state or other financial organizations who inject capital to escalate efficiency. Furthermore, the government can spot bad loans by utilising a bank’s portfolio. Then it can transmit these loans to a particular government agency for refinancing. Many transitional economies have employed this strategy in order to enhance the efficiency of banks by cleaning their portfolios and preventing subsidies for poor projects. The governments cost would have to fully afford refinancing expenses if every bad loan was transmitted. Then again, to discourage banks from rent seeking, not every single loan needs to be transferred. The purpose of refraining from financing bad loans is to achieve a hard budget constraint which is critical for a transitioning economy. Another method to achieve the same end is by encouraging capitalization which would serve as a disincentive for seeking subsidies for bailing poor projects. Nevertheless, transfer of bad loans can amount to a difficult task where the government has no clue about a bank’s portfolio. An experiment conducted by Mitchell (1995) revealed that inflicting punishment in order to discourage management will foster concealment and underestimation of bad loans (Mitchell, 1995, p.54). Conversely, studies led by other researchers illustrate that scenarios in which banks were recapitalized as a compensation for bad debts, induced them to exaggerate the bad debts figure (Aghion, 1999, p.63). The remedy to this is to relate fraction of recapitalization with the transmission of bad loans by means of bank’s portfolio. This will harden the budget constraint. Another integral query regarding privatisation under transitional mode is whether bank management should comprise of old or new management? According to the experiments carried out by researchers, an existing manager is more knowledgeable of current loan portfolio as compared to a fresh beginner (Faure-Grimand, 1998, p.4). However, as a consequence, an existing manager is in a better position to extract money if a refinancing arrangement takes place. This will aggravate the soft budget constraint as the probability of refinancing escalates. Hence, the team came to the conclusion that for hardening budget constraint, new comers should be welcomed as they do not have as sufficient information as former managers do. 4. Lender of the Last Resort It is recommended for the government to step in and help banks during liquidity crunch when the interbank lending market collapses. Although, in recent years there has been a growing trend towards rescuing banks from insolvency but bailing out banks from liquidity crunch amounts to a substantial cost. It was Thornton who first conceived the idea of a central bank acting as a lender of the last resort for other banks but he also added that lending should be restricted to “solvent but illiquid institutions”. This meant that loans should be secured against collaterals for reducing the softness budget syndrome and hardening budget constraint. In opposition to this, the non-interventionists debated that bailing out will reduce the efficiency of managers, and investing in risk prone projects will accelerate since entities would not have to cope with the repercussions ensuing from such risky investments (Goodfriend, 1988, p.7). For hardening the budget constraints, they advised that central bank should use open market operations for intervention and only get involved at the macroeconomic level. Furthermore it’s difficult to put solvency in precise monetary terms so Bagehot principal of lending to solvent banks is not a pragmatic option. In fact, it is reasonably argued that discerning illiquidity from insolvency is an impossible task. But it is essential to realise here that letting insolvent banks wind up might as well ensue in bank runs (Goodhart & Huang, 1999, p.217). After all, lending is only a must for insolvent banks. A solution to overcome softness syndrome is to limit the central bank to bail out only large scale banks. 5. Conclusion Empirical studies and experiments have divulged that some countries, for instance Hungary have taken substantial steps for hardening budget constraints whilst others like Russia are still confronted with the issue of softness. A research undertaken in 1992 in Hungary relating to medium and large entities shows that there was excessive control over credit provision. It was recorded that money losing firms had a negative bank financing but even successful firms were facing negative net bank financing, pointing to a credit crisis and excessively stringent lending policies. In opposition a similar review by certain researchers in China demonstrated that loss incurring firms had greater access to net bank financing than profitable entities (Gao, 1998, p.3). Another similar experiment was carried out in Bulgaria which indicated that interbank trade credit was contingent upon the prospects of being collectively bailed out. The hardening of budget constraints can be attributed to several institutional mechanisms. As long as banks have soft budget constraints, firms will also have the element of softness in their budgets. Bank capitalization and hospital banks can help greatly to avoid soft budget constraints faced by banks, even if they are associated with rent-seeking towards government. Instead of emphasizing a particular element, it is imperative to realise that SOEs, private entities and government compose the economic environment; thereby, comprehending the importance of these elements is crucial for the successful transition of an economy. 6. References Aghion, P., 1999. Optimal Design of Bank Bailouts:The Case of Transition Economies. Journal of Institutional and Theoretical Economics, pp.51-70. Anderson, R., 1997. Transition Banking: The Financial Development of Central and Eastern Europe. London: Oxford University Press. Berglof, E., 1995. Bank restructuring and soft budget constraints. Journal of the Japense and International Economics, 9, pp.354-75. Brandt, L., Roberts, J. & Li, H., 2003. Governments,banks, and firms: The case of privatization in China. mimeo. Toronto: University of Toronto University of Toronto. Cao, Y., Qian, Y. & Weingast, B., 1999. From federalism, Chinese style to privatization, Chinese style. Economics of Transition, 7, pp.103-31. Cull, R. & Xu, C., 2000. Bureaucrats, state banks, and the efficieny of credit allocation: The experience of Chinese state-owned eterprises. Journal of Comparative Economics, 28, pp.1-31. Faure-Grimand, A., 1998. A Positive Analysis of Bank Privatisation in Transition Economies. London School of Economics. Gao, S., 1998. Financial Discipline in the Enterprise Sector in Transition Countries: How does China compare? Watt University. Goodfriend, M., 1988. Financial Deregulation, Monetary Policy and Central Banking. Washington, D.C.: American Enterprise Institute for Public Policy Research. Goodhart, C.A.E. & Huang, H., 1999. A Model of the Lender of Last Resort. In Goodhart, C.A.E. The Central Bank and the Financial System. Cambridge: MIT Press. International Monetary Fund, 2000. Transition Economies: An IMF Perspective on Progress and Prospects. New York: International Monetary Fund International Monetary Fund. Kornai, J., Maskin, E. & Roland, G., 2003. Understanding the Soft Budget Constraint. New York: Economic Literature. Mitchell, J., 1995. Cancelling, Transferring or Repaying Bad Debt : Cleaning Banks Balance Sheets in Economies in Transition. Cornell University. Peng, M.W. & Luo, Y., 2000. Managerial Ties and Firm Performance in a Transition Economy: The nature of a Micro-Macro Link. The Acadmey of Management Journal, 43(3), pp.486-501. Perotti, E., 1993. Bank Lending in Transition Economies. Journal of Banking and Finance, 17, pp.1021-32. Read More