35 - Financial development and economic growth in transition economies

Wetenschappelijke publicatie
Date 1 January 2001

Asymmetric information and transaction costs play a central role in the economic literature explaining the importance of financial intermediaries and financial markets for economic growth. Such market imperfections are especially relevant for the countries in Central- and Eastern Europe (CEE), where well-functioning markets and legal institutions are often absent and economic uncertainty is high. As a result, information asymmetries between banks on the one hand and small and medium-sized firms on the other are large, just as the external financing premium these firms are faced with. Also, in many countries, the banking sector is still in the middle of a process of privatisation, while at the same time financial markets are only in their infancy. Furthermore, the lack of adequate "rules of the game" is reflected in perverse incentives such as soft budget constraints for (former) state-owned firms. When firms default, banks are often not inclined to institute bankruptcy proceedings against them. To a large extent, this is the direct result of a lack of effective bankruptcy laws and the absence of collateral. When banks cannot credibly commit not to refinance bankrupt firms, moral hazard behaviour by firm managers will develop. As a result, the allocative function of financial intermediaries will be distorted, as financial funds will flow to loss-making, large (state-owned) firms, while at the same time small and medium-sized firms will fully depend on their internally generated funds to finance investments. The still deficient institutional set-up, as well as the (in certain aspects) poorly functioning financial systems in CEE, may thus hinder economic growth by allocating financial resources to the "wrong" enterprises.