DP695 | Enterprise Debt and Economic Transformation: Financial Restructuring of the State Sector in Central and Eastern Europe

Publication Date

30/06/1992

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Abstract

Throughout Central and Eastern Europe (CEE), there is a widespread failure of enterprise debtors to make scheduled payments of principal and interest to creditors, who in turn have strong incentives not to declare bankruptcy. In such circumstances, the price mechanism does not properly guide the reallocation of resources. The normal process of exit in a market economy is suspended, and the disproportionate share of bank credit effectively going to refinancing of incumbents impedes entry. We argue that this may be the single most important obstacle to economic restructuring in CEE. We discuss the scope of and reasons for this problem; the inefficiencies it creates; and how to deal with it. We propose a sequencing of recapitalization of banks and of enterprises that is designed to be credible and robust to the incentive failures identified. We then assess the fiscal consequences of such a reform package and how it affects the conduct and effectiveness of monetary policy. We conclude that the international institutions must put the full weight of their authority and credibility behind such a package in order to break through the obstacles to successful restructuring.