Soft Budget Constraints, Pecuniary Externality, and China’s Financial Dual Track

I put forward a new theoretical framework to analyze the relationship between soft budget constraint syndrome and the economic performances of firms. It differs from the existing theoretical framework, à la Dewatripont and Maskin (1995), in the soft budget constraint literature. In this paper, soft budget constraint syndrome arises when firms that are expected to lose money are financed. The paper highlights a trade-off between hard and soft budget constraints. While soft budget constraints may compromise firms’ incentives to improve performances, an all-out effort to harden budget constraints may put macro stability at risk, especially for economies suffering from allocative inefficiency. Based on this trade-off, the paper shows that a transition from centralized financing to decentralized financing in fact compromises firms’ incentives to improve their performances, whereas a transition from centralized financing to a financial dual track system enhances efficiency. In the financial dual track system, budget constraints are soft in the centralized track but the macro stability of the economy is assured as a result. The macro stability enhances the disciplinary effect of hard budget constraints in the decentralized track, which in turn promotes firms’ incentives to improve performances. The paper sheds light on a complementary relation between soft budget constraint syndrome in the state sector (i.e., the centralized track) and the remarkable growth of the non-state sector (i.e., the decentralized track) in China. * I thank Michael Alexeev and Justin Y. Lin for discussions that inspired me to write this paper. I also thank Masahiko Aoki, Avner Greif, Ronald McKinnon, Paul Milgrom, Yingyi Qian, Steven Tadelis, Li-an Zhou, participants of the Comparative Institutional Analysis seminar at Stanford University and participants of the 4 International conference of transition economics in Beijing for helpful comments. I am grateful to Lawrence Lau and John Pencavel for providing me the access to the research facility at Stanford University. The author is an assistant professor at the University of Illinois at Urbana Champaign and a research fellow at the Williams Davidson Institute at the University of Michigan Business School and is currently visiting the Department of Economics and Asia/Pacific Research Center at Stanford University. Email: [email protected].