Document Type

Article

Disciplines

International Law

Abstract

Hungary is recognized as the transforming country that has made the greatest strides to date in developing its capital market. But the Hungarian example is not yet a success story; the legacies of the past weigh heavy. Since all of the transforming countries are struggling with the problem of creating capital markets, a close look at the Hungarian experience to date will provide insight into what may be reasonable expectations for. the speed with which flexible capital markets can be created during the transition. Without meaningful progress toward developing efficient financial intermediation early in the transition, privatization will be impeded and foreign investment will be discouraged. Since credibility is such an important currency for the reform designers, the lessons (harsh though they may be) must be heeded.

The legacies of the old centralized planning systems hang like albatrosses over the transformation of Eastern Europe's previously socialist economies into mixed market capitalist economies. With privatization programs stalled in many of the transforming countries, the importance of creating a flexible and effective capital market in the early stages of the transition is gaining recognition. Professor Brainard asserts that a reasonably well-functioning capital market is a necessary condition for privatization to occur on a large scale.1 Although all proposals for reforming financial institutions in transforming countries begin with imposing increased financial discipline on companies, according to Brainard, they miss the essential point and thus fail to produce the desired result. For him, the crux of the issue is balance sheet losses. He recommends "sanitizing" company balance sheets using one or some combination of bankruptcy, rehabilitation, and privatization.\

Professors Guillermo A. Calvo and Jacob A. Frenkel call for financial markets with the breadth and depth to provide the information necessary to distinguish good from bad companies, a distinction required for Brainard's proposal. 3 However, as these authors argue, financial markets in the transforming countries are not developed enough to provide this sort of outcome. Firm-specific risks that could be diversified in well-functioning capital markets remain because of inter-enterprise linkages. Overall macroeconomic and political uncertainty add to non-diversifiable risk. With inflation rates in the 30 percent to 40 percent range on an annual basis, the noise in the system makes heroic. the task of separating good and bad credit risks. Moreover, the vestiges of credit allocation in the old planning system hinder the institutional development required to support the birth of flexible capital markets. The separation of monetary and fiscal instruments and the division of the central bank and its commercial loan activity are necessary (but not sufficient) conditions for allocating credit effectively in capital markets. Financial markets remain segmented due partially to the continuing planning mentality of the governmental authorities.

This paper evaluates the progress made by Hungary in creating the three major building blocks for a true capital market: the bond market, the stock market, and an independent, competitive banking sector. These are the pillars upon which the fledgling capital market of the nineties must depend for its strength. Section I describes the organizational development of Hungary's bond and equity markets and the reform of the banking sector. Section II considers in detail the problem of non-performing loans held by the newly created commercial banks. The recent literature cited above argues that the balance sheets of companies and banks must be cleaned up.' The paper then assesses the means to this end considered in the literature and provides an alternative modest proposal for Hungary. The concluding section draws several lessons for the transforming countries from the Hungarian experience to date.

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