Businesses generally stand little chance of doing well when politics is not stable. Political stability is a necessary condition for an enabling business environment. What can the business community do to help achieve sustained political stability? Experience shows more often than not they fail to do so. What keeps the private sector divided even when both their collective and personal interests are directly at stake? Such an apparent puzzle can be explained by the soft budget constraint syndrome interacting with cronyism.
The term “soft budget constraint” was originally conceived by the economist János Komai. The concept has since been regularly invoked in the literature on economic transition from socialism to capitalism. Now the concept is increasingly acknowledged to be pertinent well beyond the realm of socialist and transition economies. A host of capitalist phenomena, ranging from the collapse of the banking sector of East Asian economies in the 1990s and the business rescue packages seen in the midst of the recent global financial crises can be usefully analysed in soft budget constraint terms.
The syndrome is at work only when organisations can expect to be rescued from trouble, and those expectations in turn affect their behaviour. The more frequently financial problems elicit support in any part of the economy, the more organisations will count on getting support themselves. The government may from time to time announce they will break with past practice and refrain henceforth from bailouts. But such announcements have little effect unless combined with some institutional change that lends credibility to their claims.
Soft budget constraint syndrome alone cannot explain why business groups do not react collectively to political adversities. The divisive force in this process comes from cronyism.
Receiving economic favours
Cronyism normally means some of those close to political authorities receive large economic favours. The most visible ones usually entail ownership of a business or its operation, such as the privatisation of state-owned enterprises. More frequently, however, economic entitlements are provided through privileged access to governmental favours. The most valuable are the provision of monopoly or quasi-monopoly positions and the extension of domestic credit at highly subsidised terms. Favouritism in awarding government contracts is also important and may be as significant as the others.
Business groups in most countries often have close ties to dominant political parties and are directly involved in politics. Strong relationships with the party in power help to obtain preferential treatment and more access to funding. Firms also have opportunities to obtain economic rents created by various regulations. The government encourages banks and finance companies to lend to big business groups or specific industries, such as export-oriented sectors. For example, banks in many countries are required to provide lower than the market rate loans to agribusiness industry and small and medium enterprises. There is evidence that firms having close ties with politicians and bureaucrats receive most of these loans.
Soft budget constraints embedded in cronyism can explain why efforts from the business community to create pressure on political actors to shun dysfunctional behaviour tend to fizzle out. Even though their personal investments are at stake, there exists a conflict between individual and collective interests within the business community. In the presence of expectation about state patronisation, the strict relationship between business expenditure and earnings is relaxed because excess of expenditure over earnings (caused by political adversities) could be paid by the state through bailouts. However, in the presence of cronyism, access to such bailouts is neither universal nor automatic. It depends on political connections.
Keeping ties to political parties
Keeping ties with the ruling party increases the probability of access to economic privileges. If you are an opposition ally, you have a stronger incentive to keep that tie in a situation where the opposition has a chance to come back to power. Breaking this tie would leave you without any political connections. In addition, you risk losing gains made when the party you are loyal to was in power. So, even when you are directly harmed by the dysfunctional politics of the party in power and the opposition, you choose to count more on your political masters to come to your rescue rather than challenging them to protect your individual and collective business interests. The latter may be personally beneficial only in the medium and long-term and that too assuming the collective fight will succeed in changing political behaviour.
Politicians understand these conflicts between individual and collective business interests as well as the economists. They are therefore not deterred when business owners come out on the streets threatening united movements to create pressure on all sides in the political power play to take part fair and square without hurting the innocent public as well as the economy. They know the needle of reality will deflate these emotions as soon as the businessmen ponder about how best to protect their own balance sheets. The immediate answer they find is do not burn your political bridges if you wish to be on the train that brings the bailout packages. They are thus perceived by the politicians as mere paper tigers.
The moral of the story: The soft budget constraint syndrome combined with cronyism can result in an unhealthy symbiosis between market and politics at the cost of the collective and even the individual interests of the private players in the market. Under such conditions, business pressure groups fail to correct political failures.
Zahid Hussain is a senior economist in the South Asia Finance and Poverty group at the World Bank.
This article was first published on the World Bank blog.