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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. SITE 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 SITE 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 SITE 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 SITE 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? SITE Question 1: Does finance lead or follow? …or are both driven by some third variable(s)? SITE 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 SITE 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 SITE 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 SITE 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… SITE La tv ia P ol an d H un ga ry E st on ia S lo va ki C a ze ch R ep . U kr ai ne R om an ia 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 SITE Bu Cz lga ec ria h Re Es p. to Hu nia ng ar y 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 SITE The “Great Divide” in institutions SITE 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 SITE 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 SITE ...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)… SITE 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 SITE Re p. SITE 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 SITE Question 2: • What determines when takeoff happens and what is the role of finance? SITE 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? SITE Time line (Berglof and Bolton, 2002 and 2004) c1 c2 _____________________________________ 0 Initial endowment ω 1 Investment decision R -1 r SITE 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 SITE ? 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 SITE 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 SITE 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 SITE SITE 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 SITE 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 SITE 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 SITE Question 3: • Is it possible to jump stages of financial development? SITE 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) SITE Different starting points… • • • • • Soviet heritage Degree of central planning Experience of private enterprise Early reforms Macroeconomic overhang… SITE …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) SITE …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 SITE 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 SITE 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 SITE 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 SITE 1999 2000 2001 SITE 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 SITE .75 1 BULGARIA SITE 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 SITE 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 SITE 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 SITE Eclipsing Stock Markets? 350 300 Czech Republic Estonia 250 Hungary 200 Latvia 150 Poland 100 Romania (BSE) Russia Slovenia 50 0 1997 1998 1999 SITE 2000 Corporate Governance Triangle Management Controlling shareholders Minority shareholders SITE Other Corporate Governance Mechanisms • • • • • • • Hostile takeovers Proxy fights Board activity Executive compensation schemes Litigation through courts Bank monitoring Public opinion and media SITE 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 SITE 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 SITE 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 SITE 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? SITE 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… SITE 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) SITE 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… SITE 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? SITE 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 SITE