Finance, economic development and the transition: the East German case

Abstract

The role of banks in the transition concerns three issues: the bad loans problem, the role of banks in providing a solution to the problems of corporate governance of privatized enterprises and the access of new enterprises to finance for investment. This paper shows how the combination of early privatization of the banking system plus financial restructuring of enterprises by the Treuhand prevented the development of a 'bad loans' problem in East Germany. The merits of banks as large stakeholders in privatized enterprises has been frequently debated in Eastern Europe. Although the role of banks as owners of non-financial companies in West Germany is frequently exaggerated, there was a widespread public expectation that they would play a considerable role in the restructuring of East German enterprises. We show that their role in acquiring stakes in privatized firms in East Germany has been negligible and suggest reasons for this outcome. East Germany is characterized by a very high level of investment and the second part of the paper investigates how the financial system can affect the relationship between investment and growth. It has been argued that the inefficiencies of both development and commercial banking in the Italian Mezzogiorno have contributed to the failure there of high levels of investment to translate into growth. The efficiency characteristics of development and commercial banking in Southern Italy are contrasted with those in East Germany. Considerable attention is given to the extent of competition in commercial banking and to the delegation by the development banks of screening and monitoring activities to the commercial banks, which characterizes the German system. It is argued that the German banking system which has been transferred to East Germany does not suffer from the inefficiencies found in Italy. Evidence is provided for the convergence of the structure of banking in East and West Germany. Nevertheless, in spite of the extensive access of East German firms to development bank finance, evidence is provided that the financial system does not foster investment in intangibles such as in marketing and in R&D. This has serious consequences for those firms which are not owned by Western firms and hence do not have access to the retained earnings of the owner, nor to the ability of the owner to guarantee loans from the banking system.