**Policy Re3earch**

## **Transition and Macro-AdJustmen**

# WPS 982

This paper is a product of the Europe and Central<sup>Asia Region. An earlier version of this report was distributed under</sup> the title, "Microeconomic Response to the<sup>Economic Transformation Program: Evidence from the Largest Polish</sup> SOEs" [State-OwnedEnterprises]. Copies of the morerecentpaper(supported by<sup>theResearch Support Budget under</sup> research project RPO 676-58) are available free<sup>from the World Bank, 1818 H Street NW, Washington DC 20433.</sup> Please contact Sina Husain, room HI 1-113,<sup>extension 37139 (September 1992, 42 pages).</sup> State enterprise behavior and reform have<sup>emerged as</sup> key issues in the emerging market economies<sup>of</sup> Eastern Europe because of the size of the state manufacturing sector as measured by its share<sup>in</sup> GDP, exports, and tax revenues. The difficulties experienced by Polish state-owned enterprises (SOEs) in adjusting and responding to the new economic environment have led to fiscal imbalance, deteriorating portfolios of commercial banks, and burgeoning interfirm payment arrears.

Pinto, Belka, and Krajewski examine<sup>the</sup> economic and behavioral reactions of a significant sample of Poland's largest SOEs to the<sup>macroeco-</sup> nomic reforms introduced as part of the "big<sup>bang" in</sup> January 1990. They track the evolution of output, costs, and profits, and examine wage setting behavior, enterprise debt dynamics, and enforcement<sup>of the</sup> "'micro" hard budget constraint by banks. They conduct a firm-level analysis of the export<sup>boom and</sup> its causes and document the evolving tax burden<sup>on</sup> enterprises. Their findings are based on a survey<sup>of 75</sup> large SOEs in manufacturing during June<sup>1989 -</sup> March 1991 - six months prior to and 15 months following the big bang.

Some of the main quandtative conclusions were: The high nominal interest rate on working<sup>capital</sup> (from 50 to 72 percent for the month of January<sup>1990</sup> alone) inhibited borrowing and motivated firms<sup>to pay</sup> off zloty loans, leading to a squeeze on<sup>working</sup> capital. The huge decline in real wages<sup>led to a</sup> demand shock, witnessed by rising finished<sup>goods</sup> inventories. Consequently, the initial, unexpectedly large, decline in output could be explained<sup>by a</sup> combination of nominal interest rate<sup>shock and</sup> standard demand considerations.

f High profits in 1990 were temporary, stemming from inflationary gains on once-off inventory<sup>sales,</sup> devaluation gains on enterprise dotlar<sup>accounts, and</sup> implicit input subsidies from CMEA trade.

* Banks were lax in enforcing creditworthiness, leading to an adverse selection problem marked<sup>by</sup> loans going mainly to "bad" firmns.

- State-owned enterprises tend to be myopic, with considerable shon-run pressure on wages that<sup>works</sup> to the detriment of restructuring investments essential for reducing energy and material intensity<sup>and</sup> product redesign.

* Nominal and real wages both displayed remarkable flexibility. Employment reduction<sup>has lagged</sup> output reduction partly because partial indexation<sup>of</sup> wages to inflation has kept real wages low and<sup>partly</sup> because of the natural reluctance of worker-controlled SOEs to shed labor. So, there is clear possibility<sup>of</sup> much higher transitional unemployment once privatdzation and commercialization get<sup>underway on</sup> a large scale.

. TMe hard-currency export boom in 1990 was motivated more by slack domestic demand<sup>than</sup> higher export profitability.

The main qualitative change is a definite attitudinal shift in favor of profits and marketing in contrast to the old exclusive emphasis on production<sup>targets.</sup> But there is a serious principal-agent problem,<sup>with</sup> managers serving at the pleasure of the workers' council and no obvious owner stressing<sup>long-term</sup> viability considerations in decisionmaking.

The paper concludes by discussing the microeconomics of transformation needed to complement the largely macroeconomic big bang. The importance of addressing firm-level managerial incentives and empowering managers is emphasized in the transition to eventual privatization.

The Policy ResearchWorking Paper Series<sup>disseminate the findings of workunder way in the Bank. Anobjectiveof theseries</sup> is to get these findings out quickly, even<sup>if presentations are less than fully polished. The findings, interpretations, and</sup> conclusions in these papers do not necessarily<sup>represent official Bank policy.</sup> Produced by the Policy Research<sup>Dissemination Center</sup>