either did not invest or financed their recent investment without bank credit. It further displays the share of firms with a low (1-33%), moderate (34-67%), and high (67-100%) level of bank financing for their most recent investment. The table shows that 74% of all firms are not leveraged, either because they did not invest (40%) or invested without using bank finance (34%). Those firms which did use bank finance to invest are equally divided between low debt levels (7%) moderate debt levels (8%) and high debt levels (11%). In line with our findings on the incidence of bank credit we find that leverage is substantially higher among large, audited and export orientated firms. Roughly 25% of large, audited and exporting firms have moderate to high leverage levels, while only 15% of small, non-audited or non-exporting firms do so. Again, firm age, sector of activity and ownership seem to have little effect on leverage.

The data presented above suggest that “excessive leverage” in the region may be more widespread than recent research using financial statement data for large firms suggests. Coricelli et al. (2009) examine balance sheet and income statement data for roughly 8,000 manufacturing firms from 12 countries in Emerging Europe over the period 2001-2005. Their study aims to establish the threshold of firm leverage above which external finance reduces firm productivity. Their results suggest that on average the optimal debt level for firms in the region is around 40%. They find that the share of firms with leverage exceeding this level ranges from less than 5% in Slovenia, Slovakia and Hungary to more than 15% in Bulgaria, Latvia and Russia. The BEEPS data presented above suggest that among a representative sample of firms in the region nearly 20% display excessive leverage levels (according to the Corrichelli et al. 2009 threshold).

What does this imply for the threat of **debt overhang** in the region? The theory of debt overhang suggests that high levels of existing debt will affect the future operations and investment of those firms that have been hit by a negative shock (Myers 1977). For these firms, the returns from positive NPV projects in the future may be partly go towards paying off existing obligations, and therefore may not be undertaken. Whether or not Emerging Europe faces a debt overhang among firms, depends therefore on whether those firms which are highly leveraged are those which were also strongly hit by the recent crisis. In Figure 4.1 we examine whether this is the case. Figure 4.1.a plots the share of firms with moderate or high leverage in 2008/2009 (exceeding 33% of recent investment) per country against GDP growth per country in 2009. This figure suggests that four countries in the region may indeed suffer from debt overhang. The Baltic states Latvia, Lithuania and Estonia all have more than 25% of highly leveraged firms and with a GDP contraction of 14%-18% in 2009 were among the most severely hit economies in the crises. In addition, Slovenia and Croatia have shares of highly leveraged firms exceeding 30% and at the same time experienced contractions of more than 5% of GDP in 2009. At the other end of the scale, countries such as Poland and Albania have few highly leveraged firms and experienced mild GDP contractions during the crisis.

Given the dramatic decline in export income to the region in 2009 and 2010 and the high leverage levels among exporting firms (see Table 4.2), the **tradable sector** may be most prone to debt overhang. Figure 4.1.b examines for which countries debt overhang in the tradable sector may be a particular issue. The figure plots the share of moderately and highly leveraged firms within the tradable sector against the aggregate decline in export volume in 2009. Latvia, Lithuania Estonia, as well as Macedonia and Slovenia are most likely to be affected by debt overhang in the tradable sector: In each of these countries. more than a third of the exporting firms are highly leveraged, and these countries experienced substantial contractions in export 26