Corporate Finance and Restructuring: Evidence from Central and Eastern Europe Non-Technical Summary

Abstract: After the end of communism enterprises in Central and Eastern Europe (CEE) were marked by low levels of labor productivity, mainly because of too high employment levels. According to economic theory, the corporate capital structure can be an important element in the restructuring process. But both, empirical evidence on corporate finance in CEE countries and its relation to employment is still sparse. This study describes the patterns of the corporate capital structure for ten CEE countries over the years 1993-1998, taking two major Western economies as a benchmark. An impressive rise in total indebtedness suggests that there is room for creditors to fulfill their role in corporate governance. On the other hand, investment is predominantly financed internally in CEE firms, making creditor and shareholder governance more difficult. But a regression analysis shows that inefficient CEE firms are forced to downsize employment when they finance themselves largely externally, but less so for those firms with high levels of debt. However, downsizing is limited by soft budget constraints. Non-Technical Summary After the end of communism enterprises in Central and Eastern Europe (CEE) were marked by low levels of labor productivity and low levels of debt. At the same time, the financial sector did not function as an intermediary of financial resources as in developed Western economies. Also, it did not fulfill its control function over debtors' activities. The central question of this study is whether the corporate capital structure works as a disciplining device in CEE enterprises, or more specifically, whether creditors can fulfill their corporate governance function by forcing inefficient firms to downsize. Based on firm-level data for the period 1993-1998, we find the following patterns of corporate finance for CEE companies: • Indebtedness of CEE enterprises has increased rapidly during transition, although the total level of debt is still lower than in Western firms; the dominance of short-term debt has weakened only slightly during transition; coverage of current liabilities has declined, indicating shrinking liquidity of CEE firms. • Labor productivity is much lower than in Western enterprises, indicating low efficiency; funding from current income reaches or exceeds Western levels, probably due to still less intensive competition in CEE product markets; during transition, productivity as well as reserves have increased rapidly, and growth of sales and current income have decreased. • CEE firms finance themselves predominantly internally, and external finance by debt is much more important than external finance by equity; during transition, internal finance has become much more important in all CEE countries with the exception of Poland; the likelihood of soft budget constraints has increased, and is the largest in Romania and the Czech Republic during 1996-1998. • Slovenia, Hungary, Poland and the Czech Republic are the most advanced economies in terms of efficient usage of resources; Estonia, the Czech Republic and the Slovak Republic show the highest levels of debt. Taken together, these descriptive results suggest that there is room for corporate governance exercised by creditors: CEE enterprises are already highly indebted after only ten years of transition, and their liquidity is shrinking, possibly indicating hardening budget constraints. At the same time, CEE enterprises finance themselves largely internally, even more so during later transition, making corporate governance action from creditors, but also from shareholders more difficult. In a more formal analysis we examine the effect of financial pressure on downsizing under ceteris paribus conditions. We find that firms with a larger burden of debt do not downsize significantly more, but that firms, which finance themselves largely by debt, show significantly larger downsizing activity. This effect is stronger, the lower the total burden of debt is. This suggests that financial intermediaries are already able to fulfill their monitoring function by pressing CEE firms to downsize, but only when these firms are dependent on bank finance. Likewise, firms which show larger inflows of capital from equity issues show larger downsizing activity -an indicator of corporate governance action by shareholders. Downsizing seems to hit the 'right' firms as inefficient firms reduce their labor force significantly more. Finally, firms which are likely to have soft budget constraints reduce employment significantly less. There is evidence that this kind of governmental support limits restructuring especially in Bulgaria and Romania