Download The Great Divide and Beyond - Financial Architecture in Transition

Emerging Capitalism:
Some Lessons from Financial
Transition
Erik Berglof, SITE, Stockholm School of Economics
at
New Economic School, October 15, 2004
SITE
The Great Divide and Beyond Financial Architecture in Transition
and
Law Enforcement, Financial Development, and Fiscal
Responsibility
(with Patrick Bolton, Princeton University)
+
Emerging Controlling Owners,
Eclipsing Markets?
- Corporate Governance in Central and Eastern Europe
(with Anete Pajuste, SITE, Stockholm School of Economics)
SITE
Provocative Propositions
• Finance played little role in generating growth in
transition; financial expansion could even
undermine growth.
• Finance, rule of law enforcement, and the
deepening of democracy are intimately linked
• Emerging economies have to go through a phase
where commercial banks and controlling owners
dominate.
• Finance has an important role to play in the catchup phase.
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The Great Divide(s)
130
OECD
120
110
CE-North + Baltics
100
CE-South
90
80
CIS-Peace
70
60
RUSSIA
50
UKRAINE
40
1990
1991
1992
1993
1994
1995
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1996
1997
1998
1999
Bridging the Divide(s)
140
GDP Development 1989-2003
120
100
80
Hungary
Czech Republic
60
Slovak Republic
Slovenia
Estonia
40
Latvia
Lithuania
20
Poland
Russia
0
1989
1990
1991
1992
1993
1994
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1995
1996
1997
1998
1999
2000
2001
2002
2003
Financial Transition Two Observations
• Common first reform steps, but then the “Great Divide”
in finance and growth opens up
• Different initial conditions, policies, and trajectories
after “takeoff”, but converging architecture:
– Increasingly concentrated ownership, beginning separation of
ownership and control, founder capitalism
– Dominated by increasingly foreign-owned banks which lend
primarily to governments; weak and unsustainable(?) local
equity markets
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Finance and Growth
• Question 1: Does finance lead or follow?
…or are both driven by some third variable(s)?
• Question 2: What determines when “takeoff”
happens and what is the role of finance?
• Question 3: Is it possible to jump stages of
financial development?
…is financial transition the right experiment?
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Question 1:
Does finance lead or follow? …or are
both driven by some third variable(s)?
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The literature:
Law, finance and politics
• Law => Finance (LaPorta et al. 1997, 1998…)
– Legal origin => investor protection => finance (=> growth)
• Finance => Law (Coffee, 2001)
– Finance => market practices => laws (=>growth)
• Politics and Finance (Rajan-Zingales, 2000a and b)
– Politics => law and finance
• “Initial conditions” view (Acemoglu et al., 2000, 2001…)
– Initial conditions => institutions => law and finance
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Financial transition
Phase 1: Common Genesis
• Common origin (monobank)
• First reforms similar
– Separate central and commercial banking
– Split up commercial banking wing
– Attempts to deal with the inherited portfolios
• First test came with price liberalization
– Credit crunch and banking crises
– Initial inertia from enterprises
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Financial transition
Phase 2: Parting Company
• Some governments resisted bailouts, others did not
• Successful countries (CEEC + Baltic countries):
virtuous spiral of microeconomic restructuring and
macroeconomic consolidation
• Less successful countries (former SU + SEE):
soft budget constraints, a vicious cycle of financial
instability, and lack of restructuring
=> the Great Divide had opened up
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Countries on the “wrong” side:
Stuck in a vicious circle…
•
•
•
•
•
Reliable deposit markets not in place
Recurrent financial crises
Soft institutional constraints => arrears
Macro instability
Little financial development in sight…
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La
tv
ia
P
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S
lo
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C
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R
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U
kr
ai
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R
om
an
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R
us
si
a
Li
th
ua
ni
a
B
ul
ga
ria
Dom estic credits to private sector/GDP (%)
The “Great Divide” in finance
60,0
50,0
40,0
30,0
20,0
10,0
0,0
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Bu
Cz lga
ec ria
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Re
Es p.
to
Hu nia
ng
ar
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La
Li tvia
th
ua
nia
Po
l
Ro and
m
an
i
Ru a
ss
ia
Sl
ov
ak
Uk ia
ra
ine
Loan-deposit rate spread
The “Great Divide” in spreads
40,0
35,0
30,0
25,0
20,0
15,0
10,0
5,0
0,0
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The “Great Divide” in institutions
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Different Trajectories
Domestic credit to private
sector/GDP (%)
30,0
25,0
Bulgaria
Estonia
20,0
Hungary
15,0
Latvia
Lithuania
10,0
Poland
5,0
Romania
Russia
0,0
1994
1995
1996
1997
Year
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1998
1999
Ukraine
Does finance lead or follow?
• Growth and financial development
– Estonia, Poland, and Slovenia
– Czech Republic and Slovakia?
• Rapid growth and then decline in financial
development, and delayed economic growth
– Bulgaria and Russia
• No financial development, delayed growth
– Ukraine
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...finance neither leads nor
follows growth
• Little evidence of direct link between finance and
growth
– hard budget constraints help growth
– but firms rely almost exclusively on internal finance
– all external finance through foreign direct investment
=> Finance and growth are jointly determined
by some underlying variable(s)…
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Explaining the “Great Divide”
• Why some “took off” but not others?
– Macro-stabilisation + corporate restructuring
• What explains why some stabilised and restructured?
– Government commitment vs. firm pressures
•
•
•
•
Soviet heritage (central planning + industry structure)
Previous experience of democracy and rule of law
Proximity to EU (“outside anchor” + trade links)
Income distribution
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Re
p.
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Bu
lg
ar
ia
Ro
m
an
ia
Ru
ss
ia
Uk
ra
in
e
Es
to
ni
a
Hu
ng
ar
y
La
tv
ia
Li
th
ua
ni
a
Po
la
nd
Sl
ov
en
ia
Cz
ec
h
GINI-coeficient
Inequality (before and after)
60
Pre-transition
50
Post-transition
40
30
20
10
0
Were Lipton and Sachs Right?
• Macro and micro aspects of transition cannot be
separated
• Basic complementarity between fiscal (and
monetary) responsibility and microeconomic
enforcement
• Political economy critical: income distribution will
affect the support for fiscal (and monetary)
responsibility and enforcement of property rights
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Question 2:
• What determines when takeoff happens and
what is the role of finance?
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Rule of Law Puzzle
• Enforcement of property rights key determinant of
growth (North, 1991)
• Large gains from property rights to the poor (De
Soto, 2000)
• Rule of law and growth (Barro, 1997; Hall and
Jones, 1999) ....
• Rule of law, financial development and growth
(Levine, 2003)
=> If so profitable, why do we not see more
investment in rule of law enforcement?
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Time line
(Berglof and Bolton, 2002 and 2004)
c1
c2
_____________________________________
0
Initial
endowment ω
1
Investment
decision
R
-1
r
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2
Vote on platform
of taxation τ and
budget (general
public good G,
enforcement K);
median voter
decides
Returns
(R, r)
realised
Population of investors
_________________________________
ωm
0
ω
Non investors
W
Investors
Initial endowment ω
Median voter ωm
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?
ω
Some early observations:
• “Political economy” development traps pervasive
• Wealth inequality affects enforcement
• It suffrage limited to property owners => easier to
get a majority supporting rule of law, but could
also lead to excessive property rights enforcement
(“leakage” of other public goods)
• When projects are large and few => more difficult
to establish rule of law
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Financial Development And
The Rule Of Law
• Financial development can give more households
the means to invest in productive activities =>
more rule of law enforcement (also facilitiates
lending)
• But could also stimulate consumption which
crowds out productive investment => less rule of
law
• Or could be directed at financing the government
budget => less private investment => less rule of
law
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Financial Development And
The Rule Of Law (cont.)
• for a given economy, positive relation between
higher aggregate lending, aggregate investment
and second-period income
• credit plays a bigger role and is larger in more
unequal economies (but this does not always
translate into higher investment)
• economies with less redistributive policies may
see higher levels of credit, as households will be
able to rely less on government transfers to selffinance their investment
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No oligarchs in the model
• No weight in the election
– Financial development has no effect
• Have their own enforcement capacity
– Indifferent (at best) to financial development
• Or oligarchs may simply expropriate smalland medium-sized investors (R – r)
– ”Oligarchy-populist trap”
– Financial development can foster rule of law
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Escaping the ‘oligarchy-populist trap’
•
•
•
•
•
•
•
“Give today” – extensive philantropy
Build democracy – commit to future redistribution
Capture Duma –influence politics
Privatization amnesty – change constitution
Promote trade – increase the costs of populism
“Land reform” – transfer of productive assets
Promote financial development – competition
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Enlightened oligarchy no solution
• Special interests interfere with ambition to
build democracy and market economy
• President Khodorkovsky unlikely to restrain
his own powers
• Russia needs
–
–
–
–
more, not less, countervailing powers
broad range of institutional reforms
more diversified industrial structure
more international engagement
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Question 3:
• Is it possible to jump stages of financial
development?
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The Literature:
Banks vs. Markets
• Banks
– Poor infrastructure (Rajan & Zingales, 1998)
– Companies small and risky: no “thick market” externalities
(Pagano, 1993)
• Markets
– Stock markets => growth (Levine and Zervos, 1998)
• Empirical evidence inconclusive
– LDCs: financial intermediation => growth (Tadasse, 2000)
– When control for legal protection, distinction bank vs.
market finance not significant (Levine, 2000)
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Different starting points…
•
•
•
•
•
Soviet heritage
Degree of central planning
Experience of private enterprise
Early reforms
Macroeconomic overhang…
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…different policies…
•
•
•
•
•
•
•
Bad loan restructuring (Hungary vs. Poland)
“Hospital” banks (Poland vs. Czech Republic)
Bank privatization (Poland vs. Czech Republic)
Entry policy (Russia vs. Czech Republic)
Foreign entry (Hungary vs. Czech Republic)
Firm privatization (Poland vs. Czech Republic)
Stock markets (Hungary vs. Czech Republic)
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…different Trajectories…
Domestic credit to private
sector/GDP (%)
30,0
25,0
Bulgaria
Estonia
20,0
Hungary
15,0
Latvia
Lithuania
10,0
Poland
5,0
Romania
Russia
0,0
1994
1995
1996
1997
Year
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1998
1999
Ukraine
… but systemic convergence
• Strong domination for bank intermediation
– so far government rather than firms
• Investment financed through internal funds
• Most external funds from FDI
• Markets play no significant role in
corporate finance, perhaps not sustainable
• Concentrated ownership emerging
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Emerging Controlling Owners
• Increasingly concentrated ownership
• Owner-management, but begin to separate
• Increasing separation of ownership and
control, primarily through pyramiding
• Delistings following mergers and
acquisitions (domestic and foreign),
possibly also in response to regulation
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Control Increasingly
Concentrated
Dynamics of ownership concentration
60
Median ownership stake (largest owner)
55
50
45
Slovakia
Poland
Hungary
Romania
Estonia
Latvia
Lithuania
40
35
30
25
20
15
1995
1996
1997
1998
Year
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1999
2000
2001
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Fraction of data %
0
100
93%
86%
79%
72%
65%
58%
51%
44%
37%
30%
23%
16%
9%
2%
Ow nership stake
CZECH REPUBLIC
100
90
80
70
60
50
40
30
20
10
100
HUNGARY
90
Percent held
75
50
33
25
10
5
0
.25
.5
Fraction of the data
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.75
1
BULGARIA
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Ownership and Control in
Central and Eastern Europe
100
90
80
70
Estonia
Hungary
Latvia
Lithuania
Romania
Slovenia
60
50
40
30
20
10
0
0
0.2
0.4
0.6
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0.8
1
Western Europe and the US
100
90
line 0:0 to 1:100
Austria
Belgium
Germany
Italy
Netherlands
Spain
Sweden
UK
US_NASDAQ
US_NYSE
80
70
60
50
40
30
20
10
0
0 0 3 5 8 0 3 5 7 0 2 4 7 0 3 5 7 0 2 5
00 .05 .10 .15 .20 .26 .31 .36 .41 .47 .52 .57 .62 .68 .73 .78 .83 .89 .94 .99
.
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
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Emerging European Capitalism
•
•
•
•
•
•
•
•
•
Private ownership dominates everywhere
…but the state remains an important owner
Firms still owner-managed, but changing
Ownership concentration high and increasing
Corporate groupings and large foreign owners
Increasing separation of ownership and control
Bank-orientation of financial system
Consolidation of stock markets
Lack of enforcement of certain rules
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Eclipsing Stock Markets?
350
300
Czech
Republic
Estonia
250
Hungary
200
Latvia
150
Poland
100
Romania
(BSE)
Russia
Slovenia
50
0
1997
1998
1999
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2000
Corporate Governance
Triangle
Management
Controlling
shareholders
Minority
shareholders
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Other Corporate Governance
Mechanisms
•
•
•
•
•
•
•
Hostile takeovers
Proxy fights
Board activity
Executive compensation schemes
Litigation through courts
Bank monitoring
Public opinion and media
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Controlling shareholders and
other mechanisms
• Separation of ownership and control allows
concentrated control, but worsens incentives
• Ownership and control structure influences
most other governance mechanisms
– Boards
– Executive compensation schemes
– Hostile takeovers and proxy fights
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Controlling shareholders vs.
minority shareholders
• Only controlling shareholders have
incentives to monitor, but can also extract
private benefits
• Controlling shareholders critical to
restructuring, but minority capital also
important
• Separation allows control despite wealth
constraints, but undermines incentives
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Investor protection vs. market
for corporate control
• Investor protection discourages bidders
(both good and bad); reduces disciplinary
role of takeovers
• Measures to promote takeovers weaken the
protection of insiders (both minority and
controlling owners)
• Takeovers can help corporate governance,
but also suffers from agency problems
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Few alternative mechanisms
• Cannot expect much from other corporate
governance mechanisms
– Concentrated ownership undermines
• Boards
• Executive compensation schemes
• Hostile takeovers and proxy fights
– Litigation difficult but not impossible
– Bank monitoring?
– Public opinion and “free” press?
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What is the corporate
governance problem?
• Controlling shareholders have come to stay
• Main corporate governance conflict: controlling
owners vs. minority shareholders
• Few alternative mechanisms, but need to do
whatever is possible
• Preventing fraud (asset-stripping) is paramount
• Enforcement and capture of law and regulation
overriding issues
• But lack of political will…
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Why convergence?
• EU as an “outside anchor” (harmonisation)
• Global financial development and
integration?
• Natural step in financial development
– Weak institutions => “informed” finance
– “Double-sided” informational asymmetry and
moral hazard => banks averse to risk (arm’slength finance, government bonds)
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Financial transition – When
will it end?
• Not ended yet…
• The moving target: global finance in transition
– Consolidation of international banking system and
increasing cross-border activity
– Increasingly virtual nature of markets
– Accelerating integration in the Euro area?
– Changing pension systems
– Increasing mobility of international savings and
breakup of domestic financing patterns…
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Financial architecture
in transition
• What will be the role of the foreigncontrolled banks in the transition countries
in the global strategies of the parent bank?
• Are local exchanges sustainable?
• What are the niches open to these systems?
• Who will regulate and how effectively?
• How will domestic firms secure funding?
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Provocative Propositions Revisited
• Finance played little role in generating growth in
transition so far, but will be critical for next phase
• Financial development could support (but may
also undermine) the emergence of the rule of law
and democracy
• Independent equity markets are desirable, but may
not be sustainable; need to find a balance between
minority protection and incentives for controlling
owners
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