Eastern European Financial Systems: The Creation of Inside Money by

This paper offers a classification of credit markets in transition economies. It describes a continuum of systems by identifying its polar cases: countries where the entire financial system still relies on outside money, mostly republics of the former Soviet Union; and those where a more decentralized intermediation system is developing (Central/Eastern Europe). We believe that different outcomes of financial reform depend on several factors, such as initial macroeconomic conditions and a differential ability of enterprises to restructure. However, we submit that the major element is the different degree of institutional development. Our thesis is that outside money continues to dominate in circumstances when decentralized enforcement of credit is unreliable. The inability to enforce credit conditions is a more basic challenge than the scarcity of ability to assess creditworthiness (although serious in itself). As a result, there is no reintermediation of private savings, and the central bank remains the lender of first resort. The resulting money creation potentially leads to hyperinflation and capital flight, which further compromise the development of a private intermediation circuit. Ultimately, firms are induced to capture the banking sector, and more generally to build lobbying power to attract refinancing credit. In the latter system, macroeconomic stabilization has largely succeed: enforcement of credit obligations is more effective, permitting more decentralized credit decisions. However, the burden of non-performing loans, worsened by high real interest rates caused by stabilization, produces moral hazard in lending decisions. Banks have a perverse incentive to direct funding towards their former debtors, financing less efficient projects. The result is further concentration of loan portfolios, an overall lower productivity of investment and a greater concentration of risk in the transition phase. Finally, we identify an intermediate stage of transition in which decentralized credit is still not fully reliable, as it may be extended collusively to uncreditworthy borrowers. As restructuring is costly for many enterprises, and impossible for value-subtractors, a tight outside money policy subtracts more liquidity than the corporate sector can generate by internal restructuring. Marginal enterprises may then resist restructuring by extending unenforceable trade credit, recognizing that other firms will do the same. As a result, trade credit is plentiful and rapidly turns into arrears, and the probability of a collective rescue increases with the prospect of an output collapse driven by illiquidity. A collective bailout then validate the enterprises' view of