Obstacles to Transforming Centrally-Planned Economies: The Role of Capital Markets [report]

Guillermo Calvo, Jacob Frenkel
1991 unpublished
This paper identifies obstacles hindering the transformation of centrally-planned economies (CPEs) into well-functioning market economies. The analysis is motivated by the recent experience with economic transformation and restructuring in Eastern Europe and the U.S.S.R. The economic system in CPEs is highly distorted. Prices do not represent real social costs, incentives systems are absent, losses of unprofitable state-owned enterprises are automatically financed, legislations vital for the
more » ... ns vital for the functioning of markets are not in place, private ownership and property rights are underdeveloped, bankruptcy laws are absent, markets are missing, shortages prevail and, occasionally, inflation is high. The obstacles identified relate to (i) anticipatory dynamics, (ii) monetary overhang and the budget, and (iii) underdeveloped credit markets. It is demonstrated that these obstacles inhibit the effectiveness of price reform, monetary and credit policies, and trade liberalization. The analysis focuses on various ways to remove the obstacles. In this regard, a special examination is made of the implications of cleaning the balance sheets of enterprises and banks from nonperforming loans, as well as ways to enhance credibility. In the absence of such measures, privatization will be difficult since the necessary information about creditworthiness of firms is lacking. The paper concludes with a brief discussion of sequencing, safety nets. and their associated obstacles. This paper identifies obstacles hindering the transformation of centrally-planned economies (CPEs) into well-functioning market economies. The analysis is motivated by the recent experience with economic transformation and restructuring in Eastern Europe and the U.S.S.R. The economic system in CPEs is highly distorted. Prices do not represent real social costs, incentives systems are absent, losses of unprofitable stateowned enterprises sre automatically financed, legislations vital for the functioning of markets are not in place, private ownership and property rights are underdeveloped, bsnkruptcy laws are absent, markets are missing, shortages prevail and, occasionally, inflstion is high. During the transition period the old central-planning system is dismantled (or is collapsing) while the new market system (and its associated institutions and policies) is still not in place. During this transition, the economy is not any more a CPE but has not yet become a fully-functioning market economy--it is referred to as being a "previously centrally-planned economy" (PCPE). The obstacles identified in subsequent sections relate to (i) anticipatory dynamics, (ii) monetary overhang and the budget, and (iii) underdeveloped credit markets. We demonstrate how thase obstacles inhibit the effectiveness of price reform, monetary and credit policies, and trade liberalization. We explore various ways to remove the obstacles. In this regard, we examine the implications of "cleaning" the balance sheets of enterprises and banks from nonperforming loans, as well as ways to enhance credibility. The paper concludes with a brief discussion of sequencing, "safety nets," and their associated obstacles. -2-1. Anticipatory dynamics The proceas of economic tranaformation and restructuring is long and complex. The pre-reform period typically starts with a lengthy delay between the tiae of the political decision to launch a transformation program, and the time of its actual implementation. During this pre-reform period, economic policies are negotiated and designed, political consensus is cemented, and key features of the institutional infrastructure are developed. In the pre-reform period actual policy reform measures are not yet implemented, and many of the basic features of the economic system are still of the CPE variety. However, the private sector, being clearly aware that fundamental changes are planned, modifiea the patterns of its consumption and assets holdings. As illustrated by the recent experience in Bulgaria, Czechoslovakia, Romania and the U.S.S.R., the private sector's behavior during the pre-reform period is governed by the expectations of the reform rather than by the policy measures themselvea. Such anticipatory actions reflect themselves in prices, exchange rates, rates of interest, foreign exchange reaervea and other important economic variables. Such anticipatory changes are not without cost. Since many of them occur prior to the removal of administered prices, they may aggravate the welfare cost of existing distortions. In addition, since the private sector and policymakers are not fully familiar with the workings of market forces, they may get confused observing that key economic variables exhibit sharp changes, while economic fundamentals (policy measures and institutions) have not yet changed. Faced with these realities, policymakera, whose mentality and attitude mmy still reflect the legacy of central planners, may be tempted to offset the undesirable consequences of anticipatory dynamics. However, in order to succeed in offsetting such disruptions, policymakers would need to adopt an extremely complex fine-tuning strategy requiring a detailed and precise knowledge of the economic system. Since such knowledge cannot be assumed, the fine-tuning strategy is likely to add to the "noise" in the economic system, amplify the confusion, and erode credibility (Calvo and Frenkel (1991a)). These considerations suggest that the transitional pre-reform period characterizing the early stages of transformation should be as short as possible. The most effective way to remove the obstacle of anticipatory dynaaics is through quick articulation and implementation of the program-thereby reducing the likelihood that anticipatory dynamics aggravates the distortions--and through the adoption of clear policy rules--thereby enhance credibility and reduce the likelihood of noisy fine-tuning. 2. Monetary overhang and the budget One of the features of PCPEs, especially during the early stages of transformation, is the presence of a "monetary overhang." Thia overhang has accumulated over the years. Governments in the CPEa have financed their budget deficits through money creation, and enterprises have enjoyed "soft" budget constraints as losses were automatically financed through credit creation. At the same time, the shortages of goods were not allowed to result in an open inflation, which was suppressed by the governments' adainistered-pricing strategy.
doi:10.3386/w3776 fatcat:etoleshp5fandprvlw574jiz3i