Kagawa University Economic Revieω Vo.l70, No..3, December1997, 177-186
A N
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on Bad-debt and Banking i
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Emerging Markets -t
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Case
Ravindra R
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Ranade
Anna Drobnik
(This note is a result of the preliminary work done on what was planned to be a graduation thesis of Drobnik. She had to cut short her stay at Kagawa University after only six months for family reasons and this note is at best the starting point of a potentially interesting model building exercise. During 1996, Ranade spent six months in Cambridge, M A, USA and got interested in the work being done there by Professor Hart and others on the theory of debts, negotiations and contracts. Drobnik's past experience in the Polish banking industry and Ranade's interest resulted in this note.. Ranade wishes to acknowledge the generousJ apanese Education Ministry grant for visiting USA and Drobnik wishes to acknowledge the pleasant stay at Kagawa University during April-September, 1997)
I. Introduction
The Polish economy has been in transition to a market economy since 1989.. Whereas the political significance of this transition can not be overstated some grassroots problems need to be highlighted. The period of transition has been di伍cultfor enterprises as well as the institutions involved in assisting them: mainly banks.. The funding resources required to implement the new knowhow have been accompanied by the risky situations. Some of the reasons for this that immidiately come to mind are
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as follows..
There has been a lack of knowledge of commercial principles and general experience among the enterprises in the private sector“ This has
given rise to a great number of frauds and cheating cases perpetrated by pros on their unsuspecting partners.
Also the general level of private savings in the Polish economy is fairly poor. The propensity to save is not as high as some countries of great savers as, for example, Japan. The initial funds put up by the enterprises are usually very small as compared to the size of investments required.. A
1
rela仙 帥 州roOぬ似ble釘印I立山 t 1 … 削 肝 悦 州I elopedp炉仰叩rop州 rr削 王et T町 collateral a very tricky proposition..“ Inevitably, this gives rise to frauds on property that is used for the collateraL The banks, then, find it very di伍cultto sell off the collateral in case of defaults The banks on their part are not particular1y linked with each other as far as information is concerned. The absense of a joint network of commu-nications allows enterprises to borrow loans from di任erentbanks to finance the same investments against the same collaterals Among the defaulters, laundering profits seems to be a possible way in order not to pay back to the bank. It is easy to sell the main product to a fellow conspirator's outfit at a low price. Then a relabelled product selling at the usual windfall profits on which the bank does not get to claim absolves the debtor of any repay -ment problems! A related problem is that banks can not get much out of the collateral as the liquidation price is not appealing but the enterprising gentleman/lady can get a very handsome profit even out of the old machines/assets through wizardry and the repayment in not a high priority on the agenda.The not so good enterprises tend to make mistakes on the business plans and fundamental strategy -mainly out of naive optimism The
539 Emerging Markets-the Polish Case -179 problems that come up are underestimation of costs, overestimation of profits (partly) due to impossibility of additional essential investment
Finally there are problems of law being in the f1mιThe legal issues regarding taxation and duties are changing and have yet to attain a stable form. It seems worthwhile to model some of these uncertainties and come up with an economic interpretation of what appears to be a messy situation..
II.Some Special Cases of Debtors
We will provide a few examples -rather stories -now. The reader
J
hぉ totake Anna Dr伽 仙wo山 hatthey a削 rue!We will凶 ainfrom giving the names of the companies and the bank involved for the obvious reasons of privacy“The first is about the company which got into the business of slaughter -ing and processing of poultry. The machinary required and obtaind was a modern one" It was bought abroad on a US$ loan from the bank The investor was a group of 16 partners.. They were mainly rural rich farmers with big poultry farms They invested their sizable savings One of the 16 took over the management after the project was evaluated and was found feasible by specialist consultants.. The bank accepted personal property and the lines for slaughter as a collateral叶 Thefailure on the part of management to make sure of the size of the hall requir吋 sothat the lines
can be operated meant that additional funding was required for the recon -struction The investors had no profits to show even for the first repay -ment of the loan, The relationship with bank soured The debtors had no
interest in renegotiating the loan. The bank had a collateral of the lines and the possibility of liquidation was almost 0.. They were valuable only as the whole complex of building etc,. Their transfer to other location meant
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were situated within a radius of 30 kms and it was impossible to sell so many farms in such a small area for a good price A typical bad-debt situation.
A second case is that of an investor who started paper manufacturing with credit from di任erentbanks on the same collateral and then there was
a fire which destroyed the collateral Police are still investigating the fraud.
A third case is that of a famous J am maker and the collateral could be liquidated at a very high yield but the investor sold all his unlabelledJ ams to his son's company and there after renaming the product at no extra cost the handsome profits were laundered The bank can't really claim the repayment as there were no profits in the father's company.. After all, failure is not a crime and the father wants a renegotiated loan repayment.
The next one is of frozen vegetables This was a public company. The technology was excellen.t The returns were expected to be excellen.t The loan was in US$.. And then the trouble started There was no experience of foreign trade for the manageres. The $ rose 300% in 5 years. The good personal left the company for better prospects The usual employment problems of strikes, low salaries arose The returns in the interim were pOOL The public company got a good part of the loan written o妊 bythe bank and other creditors.. They were compensated by the
government issued bonds to balance their ledgers but it was a bad-debt sltuatlOn.
There were two good god-fearing women who took the loan in $ for a bakery and planned to make high quality frech bread. The dollar, how-ever, rose 200%. There was some typical oligopolistic Stackelberg war -fare and many bakeries closed down The market was full of second hand baking machinery. The two women did not trust a monopsonist in
War-541 Emerging MarketsぺhePolish Case -181ー
saw to get into a situation of uncertainty of a contract without firm long ter町1co町1町llt町lent The women have excellent relations with the bank but
just that they earn far too small a return to repay even the interest on the loan and the machinary -the collateral -can not be liquidated at a worth -while level of price A di伍cultsituation for the bank and the women
indeed
III.On the other side
The creditors have also been hampered by a veriety of problems resulting from the old order giving way The new political regime after the fall of the communist government resorted to shock therapy in 1991-92 The favored fiscal policy tool against inftation was the rate of interest“ It
was changing monthly in a very high range-even up to 60% per year This was accompanied by the exchange rate of US$ being extremely unstable. The changing rates of taxes and duties added to the mess Breakdown of assured markets in the former Soviet Union and Czechoslovakia caused a great drop in sales levels“ The state monopoly banks were used to a level
of 5% rate of interest and if an enterprise wanted a loan from one bank it was oblged to do so This relationship changed. High bad-debts inherited from the previous banks caused the new ones to put up with upto 30% of the bad-debtjcredit ratio
The spiral of debt needed to be resolved and transition of the Polish economy had to be accelerated The legislature's response to these prob -lems was to introduce the Act of Financial Restructuring of Enterprises and Banks in the end of 1991 According to this act, the public enterprises that have bad loans standing from banks as of before 31st Dec..1991 had a right to sign an agreemet about restructuring the bad debts with very convinient conditionalities These were not available to the institutions before“
-182- Kagawa Unzversity Economic Review 542 Accordingly, the enterprise could give a restructuring business plan to the bank (main creditor) and the it reviewed it. Further, this creditor must be holding at least 10% of the liabilities of the debtor..
The next step was to have the debtors discuss the budgetory conditions with other trade partners and creditors and then the creditors considering the new liability conditions Ratification of the plan by creditors who owned more than 50% of the liabilities and credits was required under the arrangement. This resulted in some cases the bad-debts amounting upto even 90% written0任andthe remaining part converted into shares held by
the creditors. The next step was to make the bank (main creditor) respon -sible for monitoring the restructuring process of the enterprise. This monitoring of management, meetings, discussions in the running of the enterprise gave more information to the creditors than what was possible earlier The bank was then sometimes able to advance an additional -otherwise considered too risky -credit for restructuring The bank was also obliged to act as a mediator in relations with new partners or investors and act in the advisory capacity. One of the troubles in this transition was the passive behavior of the debtors. They were still used to the old order and expected banks to be completely submissive and servmg.. The employees were very inclined to go on strikes because of low salaries. The link of wages with productivity was not always acceptable.. The enter -prises also had high fixed costs and non-productive investments like public housing for employees, kindergartens etc There was the usual problem of not good enough collaterals to get out of sticky situations
The implementation of this legislation helped Polish banks to sharpen up their risk awareness, competitive spirit and general management. New banks arose in place of the state monopoly or other specialist banks“ They
543 Emerging Markets-the Polish Case
strong re1ationship with the former state owned corporate clients
-183-The banks resorted a1so to mergers among themse1ves And it was on1y in 1994 that 3 commercia1 banks collapsed. 11 others were absorbed by the bigger and stronger ones. The banks were now a1so empowered to move court if the debtor does not imp1ement the restructured business p1an. The Polish case is a typica1 one. There are a 10t of economies who will find it subsequent1y necessary to reform and restructure the banking indus -try and the bad-debt prob1ems. Is it possib1e to mode1 this transition and come up with some predictions to sort the mess out? 1t seems worth trying
1V. Some distinctive features
The Polish cases that we discussed ear1ier seem to indicate the follow -ing There is an inherent uncertainty in the retums on the investments.. The projects that get bogged down in the midd1e stages are a1so unab1e to generate high retums 1ater on.. The machinary etc is inevitab1y not so readily disposab1e in case the bank decides to liquidate it. The bank a1so has some other collatera1s but wou1d rather not -may be for socio-politica1 reasons -act to 1iquidate those. The debtors are inevitab1y interested in getting the 10an repayment renegotiated-possib1y in their favor.. Some of them even try their best to defau1t
1t seems that an effort must be made to incorporate as many features as possib1e to get a rea1istic modeL Following on his own work -joint or otherwise -(1989, 1994, 1995) Professor Hart with Professor Moore has come up with a mode1 of debt, defau1t and renegotiation (1996) Since it is still a pre1iminary draft as far as we know, we will not be quoting verbatim from it. It seems usefu1, however, to present our ideas using symbo1s and sty1e similar to theirs so that we can contrast this note with their work and find for ourse1ves the right way to mode1 debt in the context of emerging
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markets After all their work seems more in line with theory of debts and contracts that is applicable in fully developed capitalistic economies
To get over the questions of assumptions, we state the following The debtor has no private liquidity (in Hart and Moore he has) but borrows the amount 1 to invest in a project from a bank against a collateral This collateral returns to him if he pays the equivalent amount C at the end to the bank -or what is the same thing analytically…the bank appropriates the collateral (C is 0 in Hart and Moore) We will assume constant returns to scale of investment, both bank and debtor are risk neutral, the project lasts for two periods, the returns are generated at the end of periods 1 and 2, the capital is fungible but depreciates per unit to 1
<
1 at the end of period 1 and is completely useless at the end of the period 2, before that it yields per unit returns of r and s respectively at the end of two periods-like Hart and Moore.. The model we have in mind, ought to have a longer gestation period but in any case this is a simple introductory exercise 1n Hart and Moore, the returns r, s and the depreciation 1 are random but s>
1 wpl and E(l)<
1As stated earlier, the emerging markets has certain peculiarities The bank -after contracting with the enterprise to invest at the level 1 -expects to get a payment P at the end of period 1 and gets the collateral or equivalent amount C at the end of 2 Obviously, when the debt contract is signed, P
+
C>
L If the bank decides to liquidate the machinary etc at period 1 then it can hope to get only a small fractiono of the depreciated capitall II and certainly the amount C at the end If the project does get into the second period then it gets P+
C if all goes well or has to renegotiate at the end of period 1, The debtor, on the other hand mayborrow some money from elsewhere -we assume costlessness for simplicity here -or even partly liquidate the machinary (it is still worth II to him
545 Emerging Markets-the Polish Case -185ー
unlike the bank) or use the modest retums Ir in order to pay back P at the end of period 1 If he reinvests his returns completely -we al10w for the possibility -then he is rewarded 1 (1+ r) s at the end of period2.. What seems to be justifiable simplification, the retums r and s are closely related and we assume that rq= s with q much bigger than unity We wi1lfurther assume that in case the debtor decides not to have anything to do with the bank after getting the investment funds and reinvesting his own retums Ir can get Ir2q. We take this amount to be less than C so that he does not
have an incentive to be an outright cheater. The problem now is to say something about debt, repayment, renegotiation of contract etc.
The best case is when the two inequalities hold and that both the bank and debtor make money, the debtor can manage to have enough to pay the bank at the end of period 1 :
1 (1 +r) rqミP+C
1 (1十r)ミP
If the second inequality holds and the first does not then the bank gets paid at the end of the period 1 and the debtor suffers at the end.. He then may beg the bank to condone a little col1ateral and that may be or may not be acceptable. We wi1lnot concem ourselves with that situation
When the second inequality does not hold then the bank and debtor need to sit down and renegotiate. After the deal, suppose the bank gets g (natural1y less than P) and the debtor final1y gets h
=
[1 (l+r)-gJ rq The col1ateral C acrues to the bankThe realization of the originally random 1 and r results in a renegotia -tion of a contract. The size of g and h depends on how powerful the bank (or the debtor) is and also if we assume randomness of q then the problems is of expected payo任s.. The simple algebra of these variables seems to
E l i -f l i t -t a b l e t -F I B -4 186 Kagawa UniversiかEじonomicReviω , 546 Polish case, This needs to be investigated further,
References
Hart, 0, Firms, Contracts, and Financial Structure(Oxford UniversityPress, 1995) Hart, 0"and l Moore,“Default and Renegotiation: A Dynamic Model of Debtぺ
University0/Edinburgh Dおじussionp,ゆer,revised August 1989
Hart, 0, and J, Moore,“A Theory of Debt Based on the Inalienability of Human Capital", Q附rterか,Journaloj Economics, CIX (1994), 841-79