Soft Budget Constraints in EU Transition Economy Enterprises

Soft budget constraints (SBCs) can be said to exist in situations where governments rescue loss-making firms in order to guarantee their survival by means of either a direct or an indirect injection of credit. The credit markets of the former socialist economies of Central and Eastern Europe were characterized, in general, by the syndrome of SBCs, whereby resources were often invested inefficiently. This paper empirically analyses the effect of joining the EU, where conditions for membership included the removal of SBCs, on restructuring the traditional financing methods for capital formation in EU transition economy enterprises. In the pre-entry period, enterprises in the transition economies are found to be sensitive to credit in financing capital formation, exhibiting the prevalence of SBCs. However, the cost of capital becomes more important in the post-entry period, which may be seen as a consequence of the reduced prevalence of SBCs, while market-driven interest rates become more important in determining investment.