Money for Expanding Capital and Liquidity Reserves

In the centrally planned economy, no capital reserves were necessary. It was enough to maintain only a very small amount of money to avoid troubles with a temporary lack of liquidity. Shortage of money was not the most significant problem for the enterprises, even if the liquidity problems have occurred (see above). Yet, in creating the market economy it became necessary to create the capital for the basic economic institutions. It may seem beyond the imagination of Western observers that enterprises, banks, and other economic agents could actually exist without capital, but it was the case. Nonetheless, they did require some artificial constructions on the passive side of their balance sheet, but such a formal problem did not pose a threat to their continued existence. Unfortunately, these constructions could not be transformed into real capital resources once the centrally planned system collapsed.

Previously, the state was treated as the omnipotent institution by politicians and the population and, as a result, no capital was necessary to ensure any obligation of financial bodies. Consequently, the state was responsible for control over their business and for supplying enough money to cover needs claimed by pensioners, patients in clinics, clients of the insurance firms, and so forth. All such expenditures were covered from the state or local government budgets.

The countries that have embarked on the path of market transformation should prepare many kinds of capital insurances to reduce the risk of business activity.

This openness for business risk can be taken as a basic feature of the economic changes. In the emerging market economy, each institution should be ready to take some risk, otherwise no innovation can take place. This risk should be, of course, limited, but means to enable market participants to take the risk if they so desire should be guaranteed. Under the former system, the scale of risk was limited to personal responsibility. Those taking high risks were punished in the administrative way. One of the most negative features of the past methods was the lack of precise determination regarding the scale of risk permitted. This used to cause uncertainty and restricted individual activity.

The application of the market system implies releasing peoples' creativity;

thus, underlying the significance of its presence. The economic units should now

Monetary Equilibrium and the Polish Economic Transformation 99 act on their own responsibility and face disciplinary measures like bankruptcy in the event of failure. The state is not automatically obligated to help them in a difficult situation. Therefore, these units should develop their own safety system, which, in any case, should be based on their own capital. If this capital does not exist, the monetary policy should facilitate its creation.

The monetary outcome is controlled by the interest on credit. In the first period of transformation, these means were not sufficiently successful and credit ceilings were implemented. Consequently, enterprises are compelled to manage their affairs under the conditions of restrictive monetary policy. Yet, the very restricted credit policy implemented in Poland in 1990-1991 resulted in new problems for the next period. After a short time, the situation was reversed: the special ceilings became superfluous as the interest rates on credits offered by banks made loans much less attractive.

In the case of Poland, the final result was recession; some may initially describe it as a natural consequence of the restrictive monetary policy. Especially modem enterprises, which were built or modernized at the end of the 1980s. were compelled to pay exorbitantly high interest. Many of them fell into the credit trap.

They borrowed when the credit was cheap, but were in the process of repayment when the credit became extremely expensive. It resulted in negative profitability and forced the firms to take short term credit to preserve financial liquidity.

At the beginning of 1992, some signs of economic recovery were noticeable.

The strongest enterprises overcame the market crisis and many could engage in the international marketplace. The revival was primarily reserved for those enterprises equipped with modem machinery and technologies. But these firms are also carrying the largest burden of the anti-inflation policy by paying very high interests on credit. This burden was extremely large in the manufacturing industry, due to the very high capital intensity of production. By creating an additional capital cost, the extreme interests on credits affected these producers. Although these enterprises were able to expand production, the low profitability forced them to face persistent liquidity problems, which dampened the potential production expansion.

Thus, Poland was confronted with the phenomena of too much money in the banks and a too small demand for credit, partially explained by the high interest rate of about 11-12% in real terms. This situation raised the question why banks did not decrease their interest rates. The reason is ve j8imple: they had to cover the cost of setting high interest rates to attract savings deposits and to cover losses caused by high obligatory reserves (bearing 0% interest) in the Central Bank. In addition, the cost of procuring money is very high for banks. About 50% of deposits are those of domestic citizens. In order to keep this money in the bank, banks should set the interest rate close to the level of the consumer price index (CPI). On the other hand, banks should set the interest rate for credits close to

the investment price index because the most important clients are enterprises in this case.

In Poland it is impossible to presently fulfill these two objectives due to the disparity between the consumer and investment price indices. The CPI is 10 points higher than the price index for investment goods. If bank policy would favor enterprises, the deposit interest should be drastically negative. The difference between consumer and investment prices' dynamics will probably persist throughout 1994. The main causes are the implementation of the tax and tariff reforms and shifting the tax and tariff burden to consumers. For three years, the subsidies for mostly consumer prices fell from 30% of state budget expenditures in 1989 to 5% in 1993. Subsidized prices will almost be completely phased out in the next several years.

In such a situation one might consider the possibility of a contemporary negative real interest rate for deposits. Its presence should not prove disastrous, especially if it lasted only a short time. It would, however, have little or no effect in Poland. The Polish population keeps about half of their money resources in foreign currency. If the real interest rate on zloty deposits will be very low or even negative, money will escape to the foreign currency accounts. This movement will cause a strong increase of the rate of exchange (depreciation of the zloty), and will generate an increased volatility in the foreign exchange and price indices.

A significant difference between the level of enterprise profitability and the level of real credit cost emerges as the result of restrictive monetary policy. If the former indicator amounts to about 3%, the latter was three times higher. This difference nearly prevents financing normal business activity with credit. The consequence has been a trend toward financing only the speculative ventures, but these are mostly undertaken by very small business. Yet, these small firms have too little capital and have existed for too short a time to gain the banks' trust.

Finally, the businessmen capable of paying such high interest did not obtain credit as a consequence of regular, formal creditworthiness tests.

These last experiences in this area are very instructive. At the beginning of the transformation process the banks have tried to continue with the old method of credit policy. It was very simple - anyone could obtain credit because credit risk was not taken into consideration. Later, the situation was reversed. In the presence of very high interest introduced to curb inflation, few debtors actually possessed the ability to repay loans. This resulted in a considerable amount of badly performing credits, now estimated at 30% of the total amount of credit provided to the economy.[4]

It is perilous for banks to hold so many bade or non-performing credits. The problem of the imposing losses for banks becomes very significant. In such a case, the whole banking sector might soon be threatened by bankruptcy. Therefore, the state must help. Probably the efforts to solve this problem will be divided between

Monetary Equilibrium and the Polish Economic Transformation 101 the state and banks. Regardless of the solution to this problem, the money supply should increase by about 2%. Only then the standard international rate of bad credits to total credits (10%) can be achieved.

The negative experiences regarding the repayment of credits has changed the attitude of banks quite markedly. Banks are now extremely cautious when giving credit, especially in the case of long term obligations. This situation affected primarily industries, which need at least a couple of years to repay outstanding debts. In order not to inhibit recovery, it might well be necessary to create a special fund of credit guarantees, probably to the amount of 0.5-1% of all credit for the commercial sector. This could be about 1-2% of the whole money supply (as of April 1993).[5]

In Poland, the banking system was very integrated for many years. Already before 1989, it was partially decentralized, but the process of equipping the banks with sufficient capital was still not completed by 1993. At the beginning of 1993, the average credibility indicator amounted to 4-5% of the banks' high risk assets.

In order to attain the 'Cook Committee' recommendations, the reserve capital in the Polish banks should be doubled. It needs additional money on the order of 0.5% of GNP.[6] The process to reach the recommended value of 8% of reserve requirement will take the Polish banking system at least two years.

Even much more time will be necessary to develop the appropriate capital basis in the insurance, health and pension funds. Until today, the system of financing pensions and health is, like in the other post-socialist countries, directly linked to the state budget; as a matter of fact, it is part of it. The expenditures for health of the population are covered directly by the budget. The pension money is obtained from the obligatory liabilities related to the salaries (45% of the payroll) in enterprises. In the case of deficit or surplus, losses and profits are taken from or added to the state budget, though the latter is more than unlikely. Since the state even guarantees liquidity regarding payments capacity, the institutions mentioned above have practically no capital reserves. The state umbrella provides a high level of security for them and their clients, but also makes them inflexible and too costly.

Indeed, this system is not only characteristic of East European countries; in fact, some of its essential features are present in Western Europe as well. The continuation of full state responsibility for social insurance programs is becoming a very heavy burden for the weak budgets in post-socialists countries. At least a part of the expenditures must be covered from other sources, mostly from the individuals' incomes. In order to make the overall system acceptable for everyone, a private insurance system must be developed. The same problems and solutions pertain to the pension funds.

The new private insurance firms should collect enough capital to ensure their obligations to clients. According to the author's calculations, even if the private

insurance firms occupy only a very small part of the pension and health insurance markets, like in Germany,[7] this mixed system would need additional capital to the order of 10% of GDP to attain a proper level social security.[8]