Chapter 3Chapter 3

Soft Budget Soft Budget ConstraintsConstraints

A question for youA question for you

Table 1: Profit margin and employees, 1993-1999 Indicator 99 98 97 96 95 94 93 Average

Profit margin (in %)

-0.61 3.36 0.40 -6.96 -1.71 -1.02 -5.87 -1.77

Number of employees

8436 9411 8771 9816 9680 9342 10044 9357

Source: Amadeus CD-ROM Note: profit margin = (pre-tax profits or losses/operating revenue)*100

Do you think this firm should be brought into bankruptcy? Why or why not? Motivate your answer.

Soft budget constraintsSoft budget constraints

Definition: Definition: The government The government

cannot commit cannot commit not to not to bail out loss-makingbail out loss-makingfirms. firms.

SBCs: different viewsSBCs: different views

Paternalistic attitude of the state (Kornai, Paternalistic attitude of the state (Kornai, 1980)1980)

Political economy incentives, bargaining Political economy incentives, bargaining between enterpreneurs and politicians between enterpreneurs and politicians (Schleifer and Vishny, 1994)(Schleifer and Vishny, 1994)

Dynamic commitment problem not to Dynamic commitment problem not to refinance in the presence of a sunk refinance in the presence of a sunk investment and in the presence of investment and in the presence of asymmetric information (Dewatripont and asymmetric information (Dewatripont and Maskin, 1995)Maskin, 1995)

Why are SBCs a problem?Why are SBCs a problem?

It may prevent unprofitable firms from It may prevent unprofitable firms from restructuring: the threat of bankruptcy is not restructuring: the threat of bankruptcy is not credible and hence incentives to restructure credible and hence incentives to restructure are absentare absent

SBCs may be an obstacle to the process of SBCs may be an obstacle to the process of sector reallocation: continued subsidies to sector reallocation: continued subsidies to loss-making firms may prevent private firms loss-making firms may prevent private firms from bidding efficiently for workers employed from bidding efficiently for workers employed in inefficient SOEsin inefficient SOEs..

Macroeconomic stability may be jeopardized Macroeconomic stability may be jeopardized because government expenditures are not because government expenditures are not under control in the presence of SBCsunder control in the presence of SBCs

How serious is the How serious is the problem?problem?

Table 2: Tax arrears in transition countries (estimates) Country

Stock (end-year) Year Total

Flow (annualized) Year Total

Remarks

Czech Republic 1993 3-4 1993 1-2 Figures are estimates based on preliminary data.

Estonia 1994 5.7 6.94-6.95 0.6 Hungary 1993

1994 6.9 7.5

1993 1994

1.2 0.7

Latvia 1994 7.0 Lithuania 1993

1994 3.7 4.4

1994

1.0

Figures include rescheduled tax arears.

Poland 1993 1994

7-9 5-7

1993 1994

1-2 0-1

Interest component is an estimate. Figures include rescheduled tax arrears.

Romania 1993 1994

1.5 4.6

1993 1994

1.5 3.1

Russia 1993 1994 1995 1996

1.5 4.0 5.2) 12.0

1994 1995 1996

2.1 1.4 7.3

Estimates are based on Goskomstat data on overdue liablilities of firms, with adjustments for sample coverage.

Slovakia 1993 4.5 Note: All figures in % of (annualized) GDP and are inclusive of principal, interest and late penalties. Source: Schaffer (1995, 1996) and author’s updates for Russia

Which firms are Which firms are concerned?concerned?

Table 3: Large loss-making firsm financed by unpaie taxes Highly unprofitable

firms* Other firms

Profitability Profit/assets (%) EBITD/assets (%)

-38.7 -15.4

6.2 16.9

Real changes in debt in 1993 as % of assets Debt to suppliers (trade credit) Debt to banks Debt to governement (taxes and social security)

-0.3 -1.2 11.7

-1.1 -0.1 0.5

Memo items Net bank financing in 1993 as % of assets Number of firms (% of sample)

-0.7 32 (16)

-0.3 170 (84)

Note: Survey of 202 manufacturing firms, Poland 1993. Medians; all figures measured as a % of end-year assets. * Highly unprofitable firms as with profit/assets < -20%. Source: World Bank Survey

ConclusionsConclusions

Soft budget constraints persist in Soft budget constraints persist in several forms:several forms:• net bank financing, i.e. soft credit net bank financing, i.e. soft credit

conditions conditions • tax arrears (also to social security)tax arrears (also to social security)• wage arrearswage arrears• trade arrears (e.g. state utility trade arrears (e.g. state utility

suppliers)suppliers)

A game theoretical A game theoretical explanation of SBCsexplanation of SBCs

BBgg, B, Bp p > 0> 0

BBl l < 0< 0

RRg g > 1> 1

RRpp+ B+ Bpp < 2 < 2 distribution of good and bad projects in general (distribution of good and bad projects in general () is ) is

commonly known but the specific project under consideration commonly known but the specific project under consideration is only known to the E at first; the G finds out about the is only known to the E at first; the G finds out about the project’s type only at the end of period 1project’s type only at the end of period 1

the G has a ‘broad’ welfare function: it cares about the the G has a ‘broad’ welfare function: it cares about the taxable returns it can appropriate (Rtaxable returns it can appropriate (R ii) and it cares about the ) and it cares about the welfare of its citizens (Bwelfare of its citizens (Bii))

no pay-offs after 1 period in case the project turns out to be no pay-offs after 1 period in case the project turns out to be badbad

3 questions we need to 3 questions we need to answeranswer

Is E going to submit/not to submit Is E going to submit/not to submit • the good projectthe good project• the bad projectthe bad project

Is G going to finance/not to financeIs G going to finance/not to finance• remember G doesn’t know whether the remember G doesn’t know whether the

project is good or badproject is good or bad Is G going to refinance/liquidate in Is G going to refinance/liquidate in

case the project turns out to be badcase the project turns out to be bad

SummarisingSummarising

The proportion of good projects (The proportion of good projects () has to be sufficiently big for the ) has to be sufficiently big for the G to choose to finance whichever project is being presented (good G to choose to finance whichever project is being presented (good or bad) to it to get funded.or bad) to it to get funded.

SBCs are expected ifSBCs are expected if

• RRpp + B + Bp p - 2 > L + B - 2 > L + Bll -1 -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 this typically holds if L is low (due to capital market

imperfections, outdated capital stock, …)imperfections, outdated capital stock, …) HBCs are expected ifHBCs are expected if

• RRpp + B + Bp p - 2 < L + B - 2 < L + Bll -1 -1

• bad projects arebad projects are not submitted, only good projects are not submitted, only good projects are submittedsubmitted

• HBCs can be promoted through demonopolisation and through HBCs can be promoted through demonopolisation and through privatisationprivatisation

Promoting HBCsPromoting HBCs

DemonopolisationDemonopolisation

• RRp p ( () + B) + Bp p - 2 < L + B - 2 < L + Bll - 1 - 1 PrivatisationPrivatisation

• welfare function of the welfare function of the government becomes less government becomes less ‘broad’‘broad’

• RRp p - 2 < L - 1 (B - 2 < L - 1 (Bpp > 0 & B > 0 & Bll < 0) < 0)

Paper: On the causes of SBCs: Firm-Paper: On the causes of SBCs: Firm-level evidence from Bulgaria and level evidence from Bulgaria and RomaniaRomania

Hypotheses that are tested: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 big firms can be ‘too big to fail’ and enjoy more SBCs in

case of difficulties case of difficulties Measurement of the variables:Measurement of the variables:

• concentration ratio within the sector (pos. related to concentration ratio within the sector (pos. related to monopol.)monopol.)

• import penetration ratio within the sector (pos. related to import penetration ratio within the sector (pos. related to comp.)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 SBCs2 measures for SBCs

Net Bank Financing SBCsNet Bank Financing SBCs• the firm suffers from SBCs if it obtains the firm suffers from SBCs if it obtains

new (bank) loans despite the fact that new (bank) loans despite the fact that it is loss-makingit is loss-making

Credit Related SBCsCredit Related SBCs• the firm suffers from SBCs if it is loss-the firm suffers from SBCs if it is loss-

making and enjoys more credit days making and enjoys more credit days than the average profit-making firm than the average profit-making firm receives, reflecting an inability to pay.receives, reflecting an inability to pay.

Empirical workEmpirical work

SBCSBCi,ti,t = = + + 11herfherfi,t-1i,t-1 + + 22importimporti,t-1i,t-1 + + 33emplempli,ti,t + + 44statestatei,ti,t + + 55foreignforeigni,ti,t + + 66municipmunicipi,ti,t + + 77insider + insider + TT

t=2t=2 time timett + + ii + + I,tI,t

i -> large and medium sized manufacturing i -> large and medium sized manufacturing firms in Bulgaria and Romaniafirms in Bulgaria and Romania

t -> time period 1995-1999t -> time period 1995-1999 regressions for the entire sample of firms regressions for the entire sample of firms

and for firms with negative profits onlyand for firms with negative profits only * refers to a statistically significant effect* refers to a statistically significant effect

Empirical resultsEmpirical results

Competition decreases the Competition decreases the likelihood for SBCs to be presentlikelihood for SBCs to be present

Privatisation makes SBCs less likely Privatisation makes SBCs less likely to occurto occur

Big firms can be ‘too big to fail’ and Big firms can be ‘too big to fail’ and enjoy SBCs when they are loss-enjoy SBCs when they are loss-makingmaking

Policy implications!Policy implications!