Presentation in
Transition economics
Göteborgs Universitet
Quarter 4, May 2006;
Student:
Norbert Lung
[This is the script for the presentation – not
a real paper]
Topic:
Financing
transition: investing in enterprises during macroeconomic transition
Structure:
- Introduction
and Overview – general aspects
- Sources
of Macroeconomic Instability
- Solvency
of the State
- Solvency
of financial institutions
- Macroeconomic
conditions as a determinant of enterprise decision making and investment
performance
- Sources
of differential enterprise investment performance
b. Macroeconomic distortions
- Simulation:
effects of the macroeconomic environment on enterprise performance and
financing
- Simulation
of financial performance of investments in three stylised enterprises
across countries in transition.
i.
The
framework
ii.
Investment
in
iii.
Investment
in existing assets
- Main
conclusion
Introduction and
Overview – general aspects
This presentation will give you an insight in
the thematic of macroeconomic transition and how this transition is going to
affect the performance of enterprises. The presentation is based on the
literature published by the European Bank of Reconstruction and Development
(EBRD). It involves the working paper No. 35 which was prepared in December
1998 and will be discussed more in the book: “Financial Sector Transformation –
Lessons from economies in transition”.
Macroeconomic stability in an economy boosts
the quantity and quality of investment. In turn, productive investment is one of
the key determinants of economic growth and rising living standards. Each
government should provide macroeconomic stability. It can also be said, that
there is an existing link between macroeconomic stability and economic growth. Furthermore,
macroeconomic stability is also a critical prerequisite for effective
enterprise decision-making and performance. Beside technology and skills, which
are very essential for a good enterprise performance, the macroeconomic
environment, surrounding the enterprise, are not less relevant. That is to say,
that similar investments and companies perform very differently in countries
with different macroeconomic and regulatory policies. If there are stabile
signals within a country, companies can make better decisions and thus, will be
more successful. The macroeconomic framework, implying inflation, taxation,
public spending, price stability and other elements are fundamentally
important.
From a bird’s-eye view the environment
conditions enterprise performance like this graph shows:
Moreover, the macroeconomic environment
interacts with the market structure and the regulatory and tax regimes to
influence the behaviour and performance of enterprises.
As we can see in this graph, an enterprise is
heavily influenced by its surroundings. This brings us to the central issue: if
transition involves a rapidly evolving macroeconomic environment, and this has
fundamental effects on enterprise performance, then transition must have
central implications for the financial structure of the firm, on the on hand,
and for the behaviour and performance of investors, on the other. To put it in
other words, macroeconomic conditions change during transition, hence
influencing the enterprise, in turn, enterprise outcomes condition the performance
of the enterprise’s creditors and its other shareholders.
According to the facts stated before, I will
later discuss questions such as: What are the relative roles of debt versus
equity financing at different stages of transition? Would new investors be more
keen on investing in existing assets or in
Sources of
Macroeconomic Instability
Solvency of the State
One
source of macroeconomic instability is the solvency of the state. The resources
for servicing the outstanding domestic and foreign debt must ultimately come
from two sources: a) primary budget surpluses and b) seigniorage (printing
money by the state). Monetary growth sufficiently in excess of the growth rate
of real productive capacity will sooner or later result in inflation:
seigniorage turns into the inflation tax. The amount of real resources that
governments obtain through the inflation tax is limited: as the rate of
inflation rises, the private sector substitutes for
domestic money, domestic and foreign assets (hard currencies) that are better
hedges against inflation thus, as the inflation
tax rate increases, the inflation
tax base decreases.
Inflation
has other effects on the public finances as well. First there is the so-called
Olivera-Tanzi effect according to which real tax revenues may decline with high
rates of inflation, as taxpayers delay the settlement of tax liabilities. Since
tax liabilities are generally not indexed to inflation or subject to an
enforceable interest rate, delaying payment may reduce the real value of
payments in a dramatic manner.
Insolvency
of the state can push countries to the verge of hyper-inflation. Examples are
Solvency of financial institutions
The
financial troubles of enterprises transmit and manifest themselves first as
illiquidity and often later as insolvency of their creditors in transition
economies, other enterprises and banks. Government assistance to recapitalise
banks as their non-performing loans to ailing (maroden, kranken) borrowers pile
up. Stabilisation
itself is often associated with a build-up of bad loans. This is because
successful disinflation tends to lead, initially, to very high interest rates
on local currency loans. Clearly, high and volatile real rates are
apt/practical (geeignet) to cause financial distress to debtors. High real
deposit rates, reflecting the risk premium that needs to be paid to depositors
to compensate for the risk of exchange rate devaluation and/or default of the
deposit-taking institutions, mirror the high real lending rates charged by
these to make up for potential losses stemming from the odds of borrower
bankruptcy. Both the stabilisation programme and the risk of its failure
contribute to these risk premiums. Further to stabilisation, structural
transformation exposes creditors to severe counterparty risk as debtors
are faced unexpectedly with adverse (widrig)
developments beyond their control. Thus, a creditworthy borrower may become
insolvent with changing parameters, such as for instance, key relative prices.
Especially
during the transition from plan to a market economy, a process involving
macroeconomic stabilisation and structural adjustment on an unprecedented
scale, the problems and risks an enterprise is facing are most acute. There is
a backlog (Rückstau) of loans (so called stock-problem) and the so called flow
problem which means that the reform appears to be here to stay. Even for
Western Banks it would be very difficult to measure the creditworthiness of
loan applicants.
Thus, the
state often supports the economy. The flow of funds from the state budget to enterprises is
often intermediated through the banking sector. If the government bails out
insolvent enterprises or banks directly through subsidies, this increases the
conventionally measured budget deficit. If instead it instructs the central
bank to provide subsidised credit to the enterprise, the subsidy element, the
difference between the market rate and the subsidised rate times the amount of
the loan, would, in principle, show up in the so-called quasi-fiscal deficit of the central bank.
Financial
institutions, both banks and non-banks, can be sources of acute financial
instability when inadequate regulation and supervision encourages fraudulent
behaviour on a large scale. Examples are the pyramid schemes that have operated and
collapsed in
Macroeconomic
conditions as a determinant of enterprise decision making and investment
performance
Sources of differential enterprise investment
performance
Enterprise
performance is influenced by many conditions in an economy in three ways: a)
through the quantity and quality of the endowment factors of production; b)
through the country’s market structure and the regulatory tax environment; and
c) through the stability of the domestic (as well as international)
macroeconomic environment.
One
reason for this differential investment performance is that most transition
economies are characterized by a serious imbalance between the availability of
physical capital (mostly obsolete) and human capital (often skilled and
abundant). Furthermore, enterprise performance is strongly influenced by the
regulatory framework and the structure of the product and input market. For
instance, opening up the economy to external competition is the most effective
way of exposing internationally tradable sectors, such as, industry, for
instance. In contrast, in sheltered sectors (e.g. transportation) government
actions are required to remove barriers to entry and the government should try
to increase and protect their margins and rents.
Moreover,
there is a “negative” and a “positive” list of things a government should not
do or do respectively, to promote transition. Government should not get in the
way of legitimate private initiative through excessive regulation, licensing,
unpredictable tax code, etc. It should do enforce private property rights and
the rule of law and create a stable institutional framework for regulation and
taxation. Indeed, there are two aspects of the tax structure faced by
enterprises that are critical. 1) The quality of the design
of the rules (in terms of neutrality, universality and fairness), and 2) the
predictability of the rules over time. Enterprises may be able to live
with “imperfect” tax-regulations over a specific time as long as the system is
systematic, predictable and stable. We further can say,
that the macroeconomic environment interacts with the regulatory and tax
environment in order to influence the behaviour of enterprises.
Macroeconomic distortions
High inflation, in general, is associated with
a) highly variable and uncertain inflation and b) high relative price
variability and unpredictability. Thus, high inflation produces a distortion of
market signals and results in a worsening of coordination among economic
agents’ decisions. Unanticipated inflation, in addition, redistributes real
resources from holders of nominal denominated local currency debt instruments
toward the issuers of such instruments. Furthermore, it could redistribute
wealth and income, for instance, without an adequate indexation of tax
brackets.
Inflation itself is often the visible
manifestation of unresolved social conflict about public spending and its financing. Both, high inflation and the anticipation of
fiscal and monetary corrections to control it, increase the uncertainty of the
economic environment, where companies make their decisions. For instance,
fiscal restrictions tend to lead to a cyclical decline in economy, among
others.
Further on, like Pindyck and Solimano found out
in 1993, volatility of the returns to capital has a depressing effect on
investment, especially in developing countries. They further found out, that
only inflation seems to be clearly and robustly correlated with the volatility
of the return on investment. Investment involves the commitment of resources
today in anticipation of future, uncertain returns. Therefore, an increase in
uncertainty depresses investments.
The underlying problem of generating macroeconomic
instability is that the fiscal and financial policies are unsustainable.
Sometimes, Governments try to “repress” inflation for a while by borrowing
heavily. However, this is just for short-time, in the long run these borrowings
may cause huge troubles and lead to an even higher inflation.
Simulation: effects
of the macroeconomic environment on enterprise performance and financing
Simulation of financial performance of
investments in three stylised enterprises across countries in transition.
The framework
Just in short, this simulation is made to show
the different performance of investments made in different economies that are
at different stages of transition. This exercise can be explained by following.
An investor, for instance a bank, is assumed to be interested in the ECU
returns to financing “identical companies” in four groups of countries. These
groups are: group 1:
The first company produces chocolate for export
and is referred to as “exportable” and the second one is referred to as the
“importing-company” and is a bottle manufacturer working on the domestic
market. The third enterprise, “non-tradable” is providing cargo-transportation
in the national market.
Furthermore, the microstructure is assumed to
be equal in each groups of countries (e.g.
depreciation rates, etc.) and the macrostructure (inflation, wages, prices,
etc.) are assumed to be different for each group.
The investors have two possibilities, either to
invest in “
Investment in
In this section I will “only” present the most
important facts of the results. Here we can see a statistical distribution of a equity investment in a
As we can see, the investment in the advanced
economy (group 1,
Regarding the question if loans or equity
should be used it can be said, that the attitude towards risk of the investor
is influencing this choice, however, debt (loans) becomes less attractive at
earlier stages of transition because of higher probability of bad outcomes
(distribution - fatter tails, etc.).
Investment in existing assets
A central message of the working paper of the
EBRD is that if a country has a highly unfavourable macroeconomic environment,
it will pay for it through high discounts on the prices of its existing
immobile assets. Therefore, countries that are less advanced on the transition
path, offer the most discount and hence, the incentive for investors is higher
in investing in existing assets in those countries in early stages of
transition.
We can see this here too:
Again, here it is better for investors to use
equity instead of debt to finance their investments because, as stated before,
they invest in countries with early stages of transition and we, they
respectively don’t know the economic development and the stability of the macro
economy.
Main conclusion
What I’d like you to take along from this
presentation is that the macroeconomic environment has a powerful influence on
the performance of enterprises and investments. Especially in countries of
early stages of transition the macroeconomic conditions can change very quickly
and are unpredictable and, if some of you should become a manager and has to
decide whether to invest in this or in this country, company respectively, I
hope you remember some facts of this presentation and be aware of the difficult
situation. Thank you for the attention.
The content of this
presentation is from:
Literature: Willem H. Buiter,
Ricardo Lago and Hélène Rey,
(1993); Financing transition: investing in enterprises during
macroeconomic transition; Working Paper No. 35; EBRD-online;