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Chapter 3

Chapter 3. Soft Budget Constraints. A question for you. Soft budget constraints . Definition: The government cannot commit not to bail out loss-making firms. SBCs: different views. Paternalistic attitude of the state (Kornai, 1980)

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Chapter 3

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  1. Chapter 3 Soft Budget Constraints

  2. A question for you

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

  4. SBCs: different views • Paternalistic attitude of the state (Kornai, 1980) • 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)

  5. 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

  6. How serious is the problem?

  7. Which firms are concerned?

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

  9. A game theoretical explanation of SBCs • Bg, Bp > 0 • Bl < 0 • Rg > 1 • Rp+ Bp < 2 • 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 • the G has a ‘broad’ welfare function: it cares about the taxable returns it can appropriate (Ri) and it cares about the welfare of its citizens (Bi) • no pay-offs after 1 period in case the project turns out to be bad

  10. 3 questions we need to answer • Is E going to submit/not to submit • the good project • the bad project • Is G going to finance/not to finance • remember G doesn’t know whether the project is good or bad • Is G going to refinance/liquidate in case the project turns out to be bad

  11. Summarising • 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. • SBCs are expected if • Rp + Bp - 2 > L + Bl -1 • bad projects are submitted and are subsequently refinanced • this typically holds if L is low (due to capital market imperfections, outdated capital stock, …) • HBCs are expected if • Rp + Bp - 2 < L + Bl -1 • bad projects arenot submitted, only good projects are submitted • HBCs can be promoted through demonopolisation and through privatisation

  12. Promoting HBCs • Demonopolisation • Rp () + Bp - 2 < L + Bl - 1 • Privatisation • welfare function of the government becomes less ‘broad’ • Rp - 2 < L - 1 (Bp > 0 & Bl < 0)

  13. Paper: On the causes of SBCs: Firm-level evidence from Bulgaria and Romania • Hypotheses that are tested: • 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 • Measurement of the variables: • concentration ratio within the sector (pos. related to monopol.) • import penetration ratio within the sector (pos. related to comp.) • firm-level data on ownership • firm-level data on employment • firm-level data on SBCs

  14. 2 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.

  15. Empirical work • SBCi,t =  + 1herfi,t-1 + 2importi,t-1 + 3empli,t + 4statei,t + 5foreigni,t + 6municipi,t + 7insider + Tt=2 timet + i + I,t • i -> large and medium sized manufacturing firms in Bulgaria and Romania • t -> time period 1995-1999 • regressions for the entire sample of firms and for firms with negative profits only • * refers to a statistically significant effect

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

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