Soft Budget Constraints, Pecuniary Externality, and Financial Dual Track

Posted: 11 Oct 2001

See all articles by Jiahua Che

Jiahua Che

affiliation not provided to SSRN

Date Written: 2001

Abstract

This paper analyzes financial dual track in China. We show that the co-existence of a soft-budget track (under centralized financing) and a hard-budget track (under decentralized financing) can be strictly more efficient than the two pure cases. Our argument is as follows. First, a hard budget constraint alone is not sufficient to induce sound firm performances, positive incentives in terms of firms' profitability are needed as well. Second, for an economy such as China where many firms are hopeless money losers, there is pecuniary externality in financing. That is, the total number of firms financed into operation in the economy can affect the profitability of all firms. This paper offers a number of examples of such externality. In such an economy, centralized financing helps internalize the externality, improving firms' profitability, and yet it leads to a soft budget constraint. Under decentralized financing, budget constraint is hard, but firms suffer from low profitability. A financial dual track does better: the existence of the soft-budget sector improves profitability, enhancing the disciplinary effect in the hard-budget sector. Based on this analysis, the paper sheds light on the complementary relation between soft budget constraint syndrome in the state sector and the remarkable growth of the non-state sector in China

Suggested Citation

Che, Jiahua, Soft Budget Constraints, Pecuniary Externality, and Financial Dual Track (2001). Available at SSRN: https://ssrn.com/abstract=285401

Jiahua Che (Contact Author)

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