[MUSIC] The soft budget constraint is a key problem facing the performance of China's state-owned banks. In this presentation I want to talk about defining what is a soft budget constraint. And then the incentive problem that underlies it. And finally talk about ways in which it is possible to harden budget constraints. The soft budget constraint was originally coined by Janos Kornai, a Hungarian economist, who noticed and observed that this was a fundamental can send the problem affecting social systems. He defined the soft budget constraint as the softening of the budget constraint that occurs when the strict relationship between expenditure and earnings has been relaxed. Because excess of expenditure over earnings will be paid by some other institution typically by the state. Now economist are used to think about a budget constraint if we're a household or an individual and we're trying to purchase goods. We know that we only have fix amount of funds that can be used to purchase those goods, and this defines the feasible set of consumption choices. But if it's possible to spend beyond those means, then almost anything becomes possible and it becomes very hard to be disciplined in terms of the spending choices that are made. Kornai continues, a further condition of softening is that the decision maker expects such external financial assistance with high probability, and this probability is built firmly into his behavior. And here Kornai's decision maker is really the firm manager who is borrowing from the banks. That because they know that the bank is going to subsidize them or bail them out if their have a problem, this affects their decisions. They're going to take excessive risk or not worry about excessive losses. Now, there are different dimensions of this soft budget constraint problem. The recipients of the subsidies can be enterprises, which we're going to focus on in this presentation, or they can be local governments, or other organizations that are getting subsidies. The providers of the subsidies are usually the governments, but can also be the banks, which is, in our case, the state owned banks connected to the governments or other economic agents. And the ways in which the subsidy is provided can be through different channels. It can be through direct subsidies from the government budget, it can be through tax rebates or differential tax rates, it can be through credit bank loans which is what we're going to focus on. And finally, it can be through administrative pricing, you can get favorable prices as a way of supporting enterprises. In China, the key soft budget constraint problem is state bank lending to state-owned enterprises. And here you can see a figure which gives you a sense of the complexity of the relationships that you can have both fiscal subsidies or financial support through loans from the upper level governments to the local governments comes and then, down to the enterprises. The local governments, in terms of the financial side really means the local branches of state-owned banks. There are other example of soft budget constraints, other than Chinese state-owned banks and enterprises one might just be parents spoiling their children. If children can always ask for money, and the parents never know how to say no, they're going to be spoiled, they're not going to really know the limits, and it could lead to excessive spending by the child. Another good example is the too big to fail problems encountered during the global financial crisis where very large banks who's bankruptcy could have spill over effects to the rest of the financial market and the economy, the real economy were allowed to be bailed out by the government because the downside to the economy was too great to allow this to happen. And finally there are also other examples where governments and not just in socialist countries but even in more capitalist systems where the governments just decide these companies are too big or too important to allow them to fail. So, a good example is the US Government bailout of Chrysler Corporation to prevent unemployment of a very large number workers also after the global financial crisis. In each of these cases the recipients of these subsidies will anticipate that they'll get the support. And this could lead to a problem of moral hazard, which is just a description of the incentive problem that people will not really act responsibly if they know they're going to be rescued by the government or by banks. Let's look at the problem a bit more formally, in terms of the incentives facing the firm manager when it anticipates that it's going to have a soft budget constraint or have a subsidy provided to it in the event of failure. We can think of a firm making an effort decision, how hard to really try to be profitable. And that effort decision can lead to project success the greater the effort the more probability assess. And of course, the less effort, the more probability that you'll have financial distress. Now, if the project encounters financial problems the bank has this decision about whether to bail out firm. It can decide just to allow the firm to fail and this is often the most efficient choice the bank can make. Why throw good money after bad money? And of course, this will lead to the failure of the project or, it can decide to bail out the firm, and provide additional financing to support the project. And this may lead to a partial success, which is beneficial, of course, to the firm and avoids maybe some bad outcomes, loss of jobs, loss of revenue that the government may be worried about. And the key feedback mechanism here is that once the firms anticipate that this bail out is going to occur, then they are going to now anticipate that their own effort decision even if there is financial distress is not going to lead to project failure but going to lead to some intermediate perhaps acceptable outcome and this is going to lead them to actually exert less effort to start with. And so the sub budget constraint problem leads to poorer performance by the firms and more bad loans by the banks. Now how can we harden budget constraints in the context of China's banking system? Well, there are different ways. The first thing that China tried to do was to modify the managerial incentives of bank loan officers. To tell the bank officials that you really have to make sure that your loans are repaid. And you can do that of course just by linking promotion or bonuses to repayment rates or the profits of the bank. Or you can do what did in the mid 1990s, which is to establish a loan responsibility system where each loan officer was actually responsible for the repayment of every loan. So if the Loan was not repaid, that loan officer actually would suffer a very large kind of fine or consequence personally, for any un-repaid loan. Now that sounds like a good idea in principle but the problem is that it's pretty easy in a growing economy to hide bad loans. So it's actually difficult to know the true quality of lending. Even if on paper, it seems as if all the loans are being repaid, it could be that banks are just providing new loans to pay off old loans and the quality of loans is actually deteriorating. Only if there's an owner of the equity of the bank who really cares about the true profitability of those loans will there be a strong incentive to weed out this type of behavior. Another thing you can do is create more competitive labor and product markets to reduce the rents to employment in SOEs. In other words, if workers in state enterprises are being treated about the same as in other enterprises in a very competitive labor market, it's not a big deal to allow one enterprise to fail because those workers are going to find similar pay or other benefits in other jobs. Whereas if enterprises provide much better paying positions then people will really fight to protect the current jobs as opposed to being forced to find worse quality jobs. And finally or next you can just refuse to provide subsidies, but this is not credible. Once the firm is earning losses, if the government really does care about employment and revenues it's going to still want to bailout the firm, even if before it happened they insist they wouldn't, that's just not a credible threat. And that's the key point of the soft budget constraint problem. Now, another way to do this is to try to make banks more profit oriented. And you can do that by reforming the ownership of the bank and China has done this a little bit by trying to allow for some parts of the ownership to be publicly listed or to be owned by private firms, but most of the control is still with the state. Finally, it’s worth pointing out that even if all of these things are done, even in a market environment there's no 100% solution to the soft budget constraint problems as we saw in the bailouts of large firms and large banks in western countries after the Great Financial Crisis.
