Introduction

In this paper we discuss a problem that is not confined to the transitional economies of Central and Eastern Europe (CEE) but that is now acute in these countries. Unless it is overcome quickly, successful transition to the market may be in jeopardy. The problem is the widespread failure of enterprise debtors to make scheduled payments of principal and interest to creditors, whether to banks or other enterprises. In such circumstances, enterprise budget constraints no longer bite, and the price mechanism loses much of its significance in the reallocation of resources. Restructuring may be greatly delayed or halted completely. Not only has the normal process of exit in a market economy been suspended, entry is impeded by the disproportionate share of bank credit being allocated as refinancing of incumbents. For some time to come, this ‘crowding out’ threatens to confine the emerging private sector to small-scale activities such as retailing.

The failure of banks to enforce debt contracts with their long-standing customers should not be viewed simply as a perpetuation of the previous regime, in which finance adjusted passively to targets for the real economy. Nor is it simply a failure of political will or of management expertise. We argue that in current circumstances there may be powerful incentives for banks not to enforce debt contracts. This has three implications. First, enactment of bankruptcy laws is not sufficient for initiation of bankruptcy proceedings; there must also be appropriate incentives for creditors to foreclose. Second, until incentives are altered, the government cannot successfully delegate credit allocation in general and associated control rights over closure in particular. Centralized policy will be required.