1

CENTRE FOR ECONOMIC REFORM AND TRANSFORMATION

School of Management, Heriot-Watt University, Riccarton, Edinburgh, EH14 4AS
Tel: 0131 451 3623 Fax: 0131 451 3498 E-Mail: A.L.Scott@hw.ac.uk
World-Wide Web: http://www.som.hw.ac.uk/cert
Arrears as a Sign of Financial Repression in
Transition Economies
1
The Case of Romania
Luoana D. Santarossa
2
National Institute for Economic Research, Bucharest, Romania
University of Connecticut, Storrs-CT, USA
November 2001
Discussion Paper 2001/04
Abstract
This study looks at the signs of financial repression in a transition economy, by
evaluating to what extent perverse financial innovations resulting from soft budget
constraints interfere with monetary developments at the aggregate macroeconomic level.
Specifically, the paper investigates to what extent inter-enterprise arrears could act as
substitute for transaction money and interfere with the efficiency of restrictive monetary
policies, as reflected in money velocity. The particular case of Romania is analysed in
two settings: (i) in an ad-hoc econometric investigation on the determinants of M1 and
M2 velocity and (ii) in a simple money demand-money supply model which is estimated
with and without endogenous inter-enterprise arrears as determinant of money demand.
The general conclusion of the research is that, even though it is theoretically possible for
overdue trade debt and arrears to interfere with monetary policy effectiveness and reflect
upon the evolution of monetary aggregates, this was NOT the case with inter-enterprise
arrears in Romania between 1991-1995. The main conclusion for economic policy is that
restricting the growth of liquidity and credit in the economy through monetary measures
is not enough for hardening budget constraints.
Key words: financial repression, transition, money velocity, inter-enterprise arrears
JEL Classification Numbers: P31, P34,

1
This research was undertaken with support from the European Unions Phare ACE Programme 1998. The content
of the publication is the sole responsibility of the author and it in no way represents the views of the Commission or
its services. The author wishes to thank Prof. Mark Schaffer for invaluable academic support and guidance; the
graduate students at CERT, Heriot-Watt University, for stimulating discussion and comments, and Prof. Emilian
Dobrescu for extremely useful observations on a previous version of the paper.
2
luoana@hotmail.com or LDD93002@UConnvm.UConn.edu
2
1. Introduction
The theories and empirical analyses of financial repression and financial liberalisation
elaborated in the 1970-80s for developing economies especially Latin America and
East Asia open a little-explored avenue of research for financial liberalisation and its
consequences in transition economies (TEs from here on). In particular, Russia and the
CIS, as well as Bulgaria and Romania have faced deep financial crises that display
common characteristics with other financially repressed economies. These countries
also have had a higher degree of instability than the other, more advanced, reforming
economies of Central and Eastern Europe (CEE) such as Slovenia, Hungary, Poland,
the Czech Republic, Estonia.
The crossroads between institutional reform and macroeconomic stability provides the
setting for developing the financial system required for a faster and more successful
economic recovery. More research is needed to explore the reasons why the import of
the financial reform (deepening) orthodoxy has resulted in perverse responses in some
TEs such as Romania and Russia, but not in others, such as Hungary, Poland, or the
Czech Republic. This study will fall into this line of work and will also investigate the
relation between monetary policy and structural reform and try to identify new
directions for future policies, given the prospect of European integration for Central and
East European TEs.
Traditional macroeconomic stabilisation programs emphasise the need for positive real
interest rates to achieve sound credit markets and a distortion-free market price system,
but unfortunately exclude the need for other institutional reforms. Learning from the
experience of transition economies, IMF macrostabilisation programmes have tried,
since the mid-1990s to include elements of structural reforms a tentative co-ordination
with World Bank assistance programmes. The ability and political will to implement
efficiently the necessary institutional adjustments meant to support stabilisation have,
however, not always been consistent at national levels. Thus, the rigid and monopolised
state-owned enterprise sector (subsequently emulated also by the private sector
3
) has
resorted to perverse financial innovations (the inter-enterprise
4
, bank, wage, and tax
arrears) in order to soften the newly hardened budget constraints aggravated by severe
credit rationing. The inability of state-owned banks to impose financial discipline and
to evaluate the credit-worthiness of their clients led to over-cautious new lending that
harmed the newly emerging private sector (Dewatripont and Maskin 1995, Berglf and
Roland 1995, 1997, 1998). This outcome inverted the first stage of financial
liberalisation experienced in Latin American or Asian countries. There, commercial
banks engaged in reckless lending policies for high-risk private investment projects,

3
In Romania in 1999, for instance, the shares in total gross arrears by forms of ownership, were as follows: state
ownership 20.6%, mixed ownership 33.8%, private ownership 45.4%, and others 0.2%]
4
Inter-enterprise arrears (IEA) are defined as the overdue inter-enterprise debt. The term overdue means any
duration in excess of a normal period of payment delay and varies across countries (Rostowski 1994). Under
central planning, socialist enterprises often resorted to inter-enterprise arrears. Multilateral compensation schemes
were also usual plan-adjustments practices, as inspite financial independence claims - monetary transactions
between socialist firms fulfilled mainly accounting functions.
3
some with explicit government support. The result, however, is the same shaky national
banking systems in TEs like Romania and Russia as in other emerging markets like
Asia and Latin America. In both, commercial banks portfolios are hampered by large
non-performing loans in the former case due to implicit subsidies to large loss-making
state companies and in the latter case due to private non-performing investment projects.
This suggests that financial repression should be addressed with different policies at the
microeconomic level in TEs.
The literature on financial repression and financial reform provides a thorough
macroeconomic link between the development of financial markets and economic
growth (Fry 1982, 1993, 1995, Roubini and Sala-i-Martin 1992, Rayon 1994, Chang
1994). The need for a closer analysis of the microeconomic roots of financial
repression, however, is a new approach in the studies of financial markets in developing
and TEs (Amrit-Poser 1996, Popa 1998). The inter-enterprise arrears (IEA), as well as
the bank, tax and wage arrears phenomena provide a good example of a microeconomic
problem in the financial markets of Russia and Romania, that is believed to hamper
macroeconomic stability and growth prospects. It reflects the consequences of a
inconsistent enactment of financial liberalisation measures in a country lacking a
complete set of market institutions
5
, the knowledge and incentive mechanisms of a
competitive system.
This research will explore the macroeconomic implication as well as the roots of the
arrears phenomenon in a TE as an economic response to incomplete financial
liberalisation. The study will also determine if this phenomenon is a normal behavioural
development
6
rather than a negative consequence of liquidity rationing during transition
from centralised planning to a market system. To better illustrate the analysis, the
research will consider specifically the Romanian economy, whose experience with
arrears has been well-documented (Clifton and Khan 1993, D!ianu 1994, Rostowski
1994, Perotti and C!rare 1997, Schaffer and Turley 1999). The hypothesis is that the
problem of arrears, in general, is one factor that can explain the persistent
macroeconomic instability, and has interfered with the effectiveness of monetary policy
in Romania for the past 11 years.

5
Some authors refer to transition economies in the early stages of transformation as a weakly structured market
economy (Dobrescu 1994) or a previously centrally planned economy (PCPEs Calvo and Fenkel 1991)
6
Schmieding (1993) disagrees with the hypothesis of a credit crunch in transition economies due to financial market,
trade, and price liberalization reforms supported by Calvo and Coricelli (1992). He sees the reduction in bank credit
as a logical institutional response, once former socialist firms have to make the transition from soft to hard budget
constraints.
4
2. Trade Credit and IEA in Theoretical Debate
2.1 Methodological issues
The attempt to get to the roots of financial repression during transition meets with
practical problems: the availability, quality and reliability of enterprise (and commercial
bank) level data. To explore the transmission mechanism between microeconomic
financial behaviour and macroeconomic stability would require a specialised firm
survey beyond the capabilities of an independent researcher. The access to enterprise
balance sheet data from the fiscal authority could provide valuable information, to the
extent that they reveal the separation of financing sources into retained profits and
external funding, specifically the breakdown of the latter into equity financing, sound
bank
7
financing, overdue bank debt, overdue inter-enterprise debt and (if the case) tax
and wage arrears. However, the idea that it is the flow rather than the stock of arrears
that constitutes a structural problem is hard to test, unless the enterprise surveys are
continued during a longer period of time.
The second part of this section will outline the traditional literature on trade credit
(hereafter, TC) as a prior to investigating the role of overdue TC (IEA) in a transition
economy and its importance as part of the financial deepening process, as well as what
expected impact it has on monetary aggregates and money velocity. Section 3 presents
briefly the characteristics of Romanian transition reforms, with a particular emphasis on
the evolution of financial aggregates.
Then, the analysis will concentrate on the relevance of the inter-enterprise arrears
problem for the monetary transmission mechanism, by evaluating to what extent the
aggregate gross arrears influence the money velocity of M1 and M2 aggregates (Section
4). Section 5 concludes.
2.2 Literature Review
As the prima facie statistical analysis suggests, the financial liberalisation process
including the institutional development in the financial markets in TEs is far from
complete. Romania, in particular, illustrates how the arrears problem perpetuates the
distorted distribution of scarce credit between firms with a special bias against the newly
emerging private sector. The view of the IEA as a factor that accelerates inflation and
interferes with the effectiveness of monetary policy has received several interpretations
in the relevant literature. The first approach holds that there is no actual IEA problem,
because the average period for which TC is extended although it has increased form
the pre-liberalisation phase of transition is not out of line with normal trade customs in
developed market economies (Begg and Portes 1993, Schaffer 1998). Considering this

7
Commercial debt is still in its incipient stage in a transition economy like Romania, and private bond financing has
only been tried experimentally, in the case of a few large state-controlled firms.
5
one the null hypothesis, there are also several ways to formulate the alternative
hypothesis: that an excessive amount of overdue inter-enterprise debt does constitute a
problem in some TEs.
Coricelli (1998) notes three basic approaches to the surge in inter-enterprise debt in the
first (and subsequent) stages of economic and financial liberalisation in PCPEs. One
approach considers arrears a continuation of the soft budget constraint for SOEs
because of indecisive tightening of credit policies under political pressures of vested
interest groups. A second approach views arrears as the natural tendency toward a
market for TC that is somewhat taken to the extreme. This characterisation may have
been valid for countries like Poland and the Czech Republic, who encountered a surge
in inter-enterprise credit at the beginning of their stabilisation programs, when tight
credit policies were enforced. Once a secondary market for enterprise debt developed,
the inter-enterprise debt dropped to levels considered normal in developed market
economies. Finally, the third approach, resulting from the model of Calvo and Coricelli
(1994), argues that the presence of IEA in TEs gives rise to multiple equilibria. Since
high inflation decreases the (marginal) cost of falling into arrears (compared to the
benefits of running arrears), the chosen equilibrium will occur at the maximum amount
of defaulted payments and at an inefficient (lower) level of real output.
Very few papers dealing with IEA in transition, (a notable exception being Abel and
Siklos 1994, as well as Schaffer 1998), refer to the well documented theories of TC in
developed market economies - a segment of literature with some remarkable even if
not exactly mainstream contributions that date back to the 1960s. Quite a few studies
explore, in particular, the impact of TC on money velocity (Meltzer 1963 Nadiri 1969,
Laffer 1970, Zahn and Hosek 1973 and, with a specific reference to transition, Abel
and Siklos 1994 and Anderson and Citrin 1995)
Most authors agree that TC can replace transaction money (Laffer 1970, Ferris 1981,
Zahn and Hosek 1973, Schwartz 1974, Crawford 1992a, Nilsen 1993, Norrbin and
Reffet 1995 etc.) but also fulfils a financing function (Meltzer 1963, Crawford 1992,
Ramey 1992, Nilsen 1993, Kohler, Britton and Yates 2000) at the firm level. This gives
TC a particular dual role that makes the market for TC a particular one, cleared not by
the price (opportunity cost) of extending and receiving credit, but by altering conditions
(duration, discounts, etc.) and marginal quantity of TC granted to existing and new
customers. The distinction between demand and supply for TC, and the motives behind
them (Smith 1995) are rarely considered explicitly and even harder to test empirically
with the existing data, even in developed Western economies, much less in transition
countries.
If we look at TC as a substitute for transaction money, as it is a very short-term loan
(generally not more than 90 days in international practice), it implies that TC itself has a
very high velocity (Nadiri 1969). Alternatively, if it helps increase the number of
transactions, using the same amount of traditional money, it will appear as if the
velocity of the money aggregate M1 is increasing (Zahn and Hosek 1973). However, as
6
Laffer (1970) notes, even if TC is an almost perfect substitute for demand deposits, it is
not a substitute for time deposits (or any other interest-bearing asset in a Tobin-portfolio
approach). That is due to the fact that bank money represents generalised purchasing
power, while TC is specialised purchasing power and it cannot be used for storing
wealth
8
. Therefore, the velocity of M2 should be more stable (according to Zahn and
Hosek 1973) and less affected by the utilisation of TC. This is one important point that
I will try to test - for the case of the Romanian economy - in Section 4.
Contrary to the previous opinion, Ferris (1981) argues that non-transferrable TC does
not diminish the amount of money used in the exchange because, eventually, money has
to change hands, as in the case of immediate payment. This view would, however, not
be applicable in the case of overdue and non-repaid trade debts.
A special approach is that of the risk/uncertainty-reducing role, as well as the transaction
cost-reducing role of TC. This function is achieved by separating each goods for
money transaction into a goods for credit and a credit for money transaction (Ferris
1981), reducing, thus, the search costs the same way money eliminates the high search
costs of barter transactions
9
. This also results in TC reducing the precautionary demand
for money (Laffer 1970, Ferris 1981, Crawford 1992b) and, therefore, again, in an
increase in M1 velocity.
If we consider the emergence of TC in transition economies as a positive development
along the lines of financial intermediation and the diversification of commercial and
financial transactions (hence, a component of financial deepening - in Shaws (1973)
terminology) we should, initially, look for empirical evidence of increasing M1 velocity.
This trend is also reinforced by the increased monetisation of economic transactions
(Abel and Siklos 1994). However, the increase in M1 velocity could also be due to less
desirable developments, such as the erosion of confidence in the national currency due
to high and variable inflation, as well as the replacement of transaction money (by
liquidity constrained firms) with non-repaid commercial debt - i.e. the much debated
IEA problem
In their 1995 study on the behaviour of inflation and velocity in states of the former
Soviet Union, Anderson and Citrin find that, even in times of tighter monetary policies,
inflation dynamics has often exceeded the dynamics of the domestic broad money
aggregate. They have explained that by exogenous shocks to the price levels
10
, reflected
in significant increases in money velocity and negative real interest rates. The way out
from this (short-term) misalignment between monetary policies and inflation that caused

8
This view is contradicted, to some extent, by Laffer (1970) himself, who also introduces the concept of unutilized
trade credit as part of a firms portfolio, together with other assets, such as bank deposits, bonds and commercial
paper, etc.
9
There is also a growing literature on the re-emergence of barter in transition economies particularly in countries of
the CIS as a response to liquidity constraints and financial repression (see Amrit-Poser 1998 and Marin, Kaufman
and Gorochowskij 2000)
10
Caused by above-inflation wage increases, administrative price-hikes, external shocks through devaluation and
changes in international energy prices, etc.
7
the failure of several IMF-led stabilisation programs in many CIS economies, was, in
their view, the increase in the demand for real money balances and positive real interest
rates. Similar to Anderson and Citrin (1995), Calvo and Kumar (1994) also found in
the case of the Central and East European countries - a positive relation between the
reduction in inflation and a decline in velocity caused by an increase in savings and
holdings of financial assets, as successful stabilisation experiences fostered the
diversification of financial market instruments in the advanced reformers economies.
The increase in financial intermediation, would be reflected in an increase in M2
velocity but not in the M1 velocity, because firms access to these new financial
instruments are replacing financial assets in the nature of time deposits, that were
fulfilling a wealth storage function, rather than transaction money balances.
11
This
tendency in the demand for money by firms in an economy undergoing financial
deepening could, however, be compensated by the new availability of a more diversified
choice of financial assets for individual savers, that would also increase the demand for
less liquid assets, hence for M2 money balances and decrease the holdings of idle
money, hence of M1 money demand. This would put downward pressure on M2
velocity and upward pressure on M1 velocity. The resulting compound effect of
financial deepening on M1 and M2 velocity is, therefore, uncertain. All we can infer
form the velocity dynamics is which of these processes could be dominant at a specific
time and under specific conditions.
In the specific case of transition economies with persistent instability, if the M1 velocity
is increasing faster than M2 velocity, it is likely to be a sign of transaction money
substitution through TC and non-repaid TC (IEA), given that TC is no substitute for
money as a store of wealth hence for interest-bearing assets that are included in M2
but not in M1. It is also conceivable (according to Crawford 1992a) that an increase in
inter-enterprise debt is also accompanied by an increase in the average TC period, which
is also a distinction not often made in the relevant literature. The intriguing questions,
however, are (i) when does inter-enterprise debt become overdue and (ii) why has it
become (by the sheer size of it) a sign of concern for stabilisation policies.
The answer to the first question is depending on established trade payment practices in
each country and is rarely regulated explicitly in the national trade codes. Authors (see
Meltzer 1960, Schwartz 1974, Crawford 1992b, Schaffer 1998) have also noted that
behaviour towards late and delinquent payers depends also on the general economic
environment (more tolerant towards late payment in times of tight monetary policies), as
well as on the financial situation of the suppliers of credit themselves, at different times.
As far as the behavioural reasons behind the accumulation of a large amount of IEA in
TEs is concerned, the answer originates also from the traditional theories of trade credit.
It has been argued that the financing role (see above) of TC acts as a softening mean
for the bank-credit channel of monetary policy (Ramey 1992) when restrictive measures

11
The growth of financial intermediary liabilities should influence the demand for money inclusive of time deposits
more so than the demand for narrow money because time deposits more than narrow money provide the value
storage service for which such liabilities are a substitute Zahn and Hosek 1973, p. 203.
8
are taken. Most studies dedicated to this issue (Brechling and Lipsey 1963, Nadiri 1969,
Crawford 1992a, Nilsen 1993, Petersen and Rajan 1996, Kohler, Britton and Yates
2000, etc.) seem to indicate that large (or incorporated) firms help out their small (or
non-incorporated) customers that have a more restricted access to credit markets in
times of monetary tightness, by extending more TC than they are taking from their
suppliers. That leads Crawford 1992b to conclude that only the assumption of credit
market imperfections (or rationing) can lead to a counter-cyclical (and counter-monetary
tightening) role of TC.
The particular occurrence of overdue TC in TEs would, arguably, not be possible in the
institutional setting of a normal market economy. There, firms extending TC will
initiate bankruptcy procedures against bad debtors possibly, with some delay, if we
take Crawfords (1992a) point, that the search for customers is costly, like in the
advertising cost models (Nadiri 1969). The adverse incentives in a transition
framework, especially the underdevelopment of the bankruptcy procedures (Aghion,
Hart and Moore 1998), determines buyers and sellers to agree upon indefinitely long TC
periods, under the prevailing credit rationing conditions. Unlike in developed market
economies where:
[] in the short-run, buyers would like to shorten credit periods as bank interest
rates rise, but not once trade interest rate has risen proportionately (Crawford
1992b, p. 16).
The interest rate motive rarely plays a central role in the buyers demand for TC
12
, if
there is an expectation for a general bailout of large debtors by the government
authorities (Clifton and Khan 1993, D!ianu 1994, Perotti 1998). Crawford 1992b
continues by stating that:
in the [] case where trade credit is simply added into price, it is not clear that
the seller gains any competitive advantage by letting them overrun. (p. 16).
Again, in the unstable macroeconomic environments of TEs, the seller not only has an
incentive to add the real cost of credit to the price of products which he may well know
are sold on an indefinite period TC, but he will also incorporate a substantial margin
for anticipated inflation. The extension of TC by loss-making SOEs, for example, is
meant to cover the fact that products are manufactured at inefficient cost levels (X-
inefficiencies) and are priced to include these non-competitive costs, by some degree of
monopoly power. For them, the search costs theory from the traditional TC literature
applies in a particular way, in that, with the emergence of cost-efficient competitors on
the market, their search costs will grow infinitely.
In the particular case of Romania
13
, it is the state-run utility companies
14
(e.g. electricity,
heating, gas and water supply; freight rail transport) that have accumulated the highest
9
level of enterprise arrears (by continuing to extend TC to customers already in default).
They are counting on government support for clients that do not pay their overdue bills
and whose bankruptcy would create important social and/or political problems. (such as
the giant steel company Sidex, community services, or even some private firms
sustained by political interests.)
These are only some stylised facts that we will have to take into account when analysing
TC and IEA in TEs. A particular element to be considered is to avoid the
overreaction of some analysts and macroeconomic decision-makers with respect to the
harmful effects of the surge in inter-enterprise debt, even if it looks as if it can
contribute to the increasing and self-perpetuating inflation. This seems to be true in the
case of some TEs (e.g. Romania, the Ukraine) but not in others (e.g. Hungary and the
Czech Republic where the enterprise debt has surged initially, only to drop back to
much lower levels after bankruptcy law became operational).
As I have mentioned above, the traditional literature seems to indicate with some
exceptions, see Crawford 1992b, p. 27), that TC acts as a softening device of the
credit channel in times of monetary tightness, particularly for small firms with limited
access to financial markets (Petersen and Rajan 1996), allowing them to keep their level
of output (and input demand) at a higher level than in the absence of TC. If we extend
this argument to TEs, it follows that inter-enterprise debt has consistently been used to
counteract contractionary effects on the supply side
15
. This should have an anti-
inflationary effect in economies experiencing serious declines in real output, by helping
small, cost-efficient, but liquidity constrained firms (mainly in the emerging private
sector) to survive. This conclusion is along the line of the argument put forward by
some authors (see Amsden et al. 1994) that IMF-designed stabilisation policies have
been wrongly directed at suppressing demand, since the inflationary pressures are cost-
push rather than demand-pull in reforming post-socialist economies. Pinto,
Drebentsov and Morozov (2000) develop a more specific critique of the governments
drive to conquer inflation at all costs
16
by pointing out that, in Russia, the combination
of monetary restrictions and soft budget constraint policies have generated an explosion
of non-payments and non-cash payments of commercial and tax debt.
The more accelerated decline in retail sales and savings than the contraction of the GDP
in countries like Romania who has experienced only partial and temporary success of
such macrostabilisation programmes seems to support this point of view.

12
. Interest rates also play an insignificant role in the sellers decision to extend credit, especially if there is little
demand for its obsolete and/or low quality output.
13
For similar developments in Russia see Pinto, Debrentsov and Morozov (2000).
14
Also, the new private monopolies resulted from unwise privatization decisions such as the Romtelecom case,
sold to the Greek state-owned Telecom company may continue to work under the same adverse incentives that
prevent the adoption of efficient cost-reducing operations.
15
Large SOEs, who are the main TC suppliers, continue to work under conditions of overemployment, while all on
paper profits (counting receivables as revenues) are used to justify wage increases. This is an alternative channel
on the demand side that has to be considered when determining the TC impact on inflation.
16
Pinto, Drebentsov and Morozov 2000, p. 298.
10
Therefore, as long as inter-enterprise debt has stopped production from dropping even
more dramatically, IEA have to be seen as a temporary financial innovation
17
that has
replaced the slower advance of financial reform (deepening). However - to the extent
that IEA have validated and facilitated cost-push price increases (including X-
inefficiencies and higher inflationary expectations of TC suppliers) they are a danger
to macrostabilisation and normalisation of financial transactions and micro-level
reforms
18
.
3. Monetary and credit aggregates in Romania
in the 1990s
In the particular case of Romania, the evolution of M1, M2
19
and Quasi-money for the
19911999, (see Graph 1) reflects different stages of policy reforms, as well as the
general attempt to counteract inflation by reducing the growth of real money supply. It
is immediately apparent that there have been changes in trends, especially in terms of
the proportion of M1 and Quasi-money in the M2 aggregate. The Quasi-money
aggregate as the one including time deposits in both domestic and foreign currency
is also significant as an indicator of the resources available to commercial banks for
credit financing of businesses and government debt (see Graph 2). (Calvo and Kumar
1994) The periods of most significant macroeconomic adjustment, reflected in the
highest annual inflation rates (19921993) are characterised by a real contraction of the
M2 aggregate, as the monetary authority was trying to counteract the effect of price
liberalisation stages. This was achieved mainly by a drastic decrease in quasi-money,

17
The term innovation is not meant here as a totally new practice in enterprise behaviour (since it has long been
used during central planning), but one of several alternative ways to circumvent the new liquidity constraints
emerged during tight monetary policies under particular conditions of post-socialist transitions.
18
Dobrescu (2000) also suggests that de-capitalisation- or the erosion of firms working capital - is another danger
from the proliferation of inflation-fueling arrears. The reduction in the real value of their working capital will push
firms into running ever higher levels of arrears (and increase prices) in order to maintain production/supply levels
unchanged. That is a typical behavioural characteristic of Romanian (and other transition economies) firms,
inherited from the quantity drive motivation of central planning. Maintaining production levels at all costs is
also meant to justify existing employment levels, since most managers are driven by the need to minimise the number
of redundancies and not by profit maximisation motives.
19
Note that I use here the total amount of savings and time deposits including those denominated in foreign
currency held with domestic commercial banks.
11
while the M1 aggregate has a lower rate of decline and becomes higher than the amount
of quasi-money. The situation is reversed in 1994, when quasi-money grows again
above M1, as the saving incentives brought about by positive and higher real interest
rates start to work towards bringing down inflation and reduce inflationary expectations
of savers
12
Graph 1
Real monetary aggregates
199703
199405
199703
199311
199703
0
50
100
150
200
250
1
9
9
1
0
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M
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M
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,

Q
u
a
s
i
-
m
o
n
e
y
/
P
P
I
ReM1 ReM2 ReQM
13
Graph 2
Ratios of quasimoney and non-government credit to M1
199612
199201
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
1
9
9
1
0
1
1
9
9
1
0
4
1
9
9
1
0
7
1
9
9
1
1
0
1
9
9
2
0
1
1
9
9
2
0
4
1
9
9
2
0
7
1
9
9
2
1
0
1
9
9
3
0
1
1
9
9
3
0
4
1
9
9
3
0
7
1
9
9
3
1
0
1
9
9
4
0
1
1
9
9
4
0
4
1
9
9
4
0
7
1
9
9
4
1
0
1
9
9
5
0
1
1
9
9
5
0
4
1
9
9
5
0
7
1
9
9
5
1
0
1
9
9
6
0
1
1
9
9
6
0
4
1
9
9
6
0
7
1
9
9
6
1
0
1
9
9
7
0
1
1
9
9
7
0
4
1
9
9
7
0
7
1
9
9
7
1
0
1
9
9
8
0
1
1
9
9
8
0
4
1
9
9
8
0
7
1
9
9
8
1
0
1
9
9
9
0
1
Q/M1 NGC/M1
14
This partial stabilisation success was, however, unsustainable, as long as property and
other structural reforms were mismanaged or even delayed until late 1996. The decrease
in direct subsidies was replaced by a nominal increase in non-government credit,
particularly towards large, majority state-owned firms (the survival of which replaced
social security reform measures required by surging unemployment). However, in real
terms, non-government credit has decreased considerably until mid-1994 and has
steadily increased until early 1997, while the loss-making firms started to run deeper and
deeper into financial problems. At the same time, real gross government credit has
decreased continuously from 1991 to 1994, only to rise again since then, even if net
government credit has increased steadily from negative values in the first half of the
decade, to more than 40 billion lei (in 1990 prices) (see Graphs 3 and 4). The financing
instruments of government expenditure (and debt) have also diversified throughout the
period, government bonds becoming for the first time available to all investors in the
late 1990s. The beginning of 1997 (after general election resulting in the change of the
ruling coalition) marks a sudden surge in both categories of credit, followed
immediately by a sharp real decrease caused by turmoil in the banking sector.
Credit was severely restricted throughout the 1990s in Romania. Graph 4 shows the
evolution of real short-term commercial credit to private and state-own enterprises in
comparison to refinancing credit (regarded often as survival credit for an
undercapitalised banking sector) and net credit to the government. Even if we can
identify a, possibly, positive development in the decrease of the share of credit to state-
owned enterprises and an increase of the volume of credit awarded to private firms, this
may be partly the result of privatised firms continuing their normal credit relations with
their banks after the change of ownership. The most worrying development is, however,
the increasing demand for credit coming from the government, which could be the sign
of a crowding out of financial resources diverted from the enterprise sector towards
covering growing government expenditure.
This is a genuine concern as long as banks are more inclined to invest in low-risk
government assets (or in excess reserves deposits with the central bank which have
often brought high short-term returns
20
) instead of taking lending risks with commercial
loans risks that they are poorly equipped to assess and that are higher, the higher the
macroeconomic instability.

20
As NBR has tried to reduce inflation-fuelling liquidity on the market by raising the interest rate on reserve
deposits.
15
Graph 3
Real non-government credit and real gross government credit
(in lei billion, deflated by the PPI)
199405
0
50
100
150
200
250
300
1
9
9
1
0
1
1
9
9
1
0
4
1
9
9
1
0
7
1
9
9
1
1
0
1
9
9
2
0
1
1
9
9
2
0
4
1
9
9
2
0
7
1
9
9
2
1
0
1
9
9
3
0
1
1
9
9
3
0
4
1
9
9
3
0
7
1
9
9
3
1
0
1
9
9
4
0
1
1
9
9
4
0
4
1
9
9
4
0
7
1
9
9
4
1
0
1
9
9
5
0
1
1
9
9
5
0
4
1
9
9
5
0
7
1
9
9
5
1
0
1
9
9
6
0
1
1
9
9
6
0
4
1
9
9
6
0
7
1
9
9
6
1
0
1
9
9
7
0
1
1
9
9
7
0
4
1
9
9
7
0
7
1
9
9
7
1
0
1
9
9
8
0
1
1
9
9
8
0
4
1
9
9
8
0
7
1
9
9
8
1
0
1
9
9
9
0
1
Real non-government credit Real Gross Gov. Credits (public debt +gov bonds held by NBR+other credits to gov)
16
Graph 4
Evolution of real non-government and government
credit aggregates
199706
199605
-70
-50
-30
-10
10
30
50
70
90
110
130
1
9
9
1
1
2
1
9
9
2
0
3
1
9
9
2
0
6
1
9
9
2
0
9
1
9
9
2
1
2
1
9
9
3
0
3
1
9
9
3
0
6
1
9
9
3
0
9
1
9
9
3
1
2
1
9
9
4
0
3
1
9
9
4
0
6
1
9
9
4
0
9
1
9
9
4
1
2
1
9
9
5
0
3
1
9
9
5
0
6
1
9
9
5
0
9
1
9
9
5
1
2
1
9
9
6
0
3
1
9
9
6
0
6
1
9
9
6
0
9
1
9
9
6
1
2
1
9
9
7
0
3
1
9
9
7
0
6
1
9
9
7
0
9
1
9
9
7
1
2
1
9
9
8
0
3
1
9
9
8
0
6
1
9
9
8
0
9
1
9
9
8
1
2
1
9
9
9
0
3
l
e
i

b
i
l
l
.
,

1
9
9
0

p
r
i
c
e
s
Short-term credit to non-government, economic agents with majority state-owned capital (end of period)
Short-term credit to non-government, economic agents with private capital (end of period)
Refinancing credits from NBR (daily average)
Net Governmental credit (end of period) (Credits-deposits of government institutions)
17
The banks are not the only ones who are unwilling to take investment risks in a highly
unstable environment, but savers also have been increasingly prone to keep savings in
foreign currency denominated deposits (see Graph 5) up until 1994, when high nominal
(and real) interest rates on national currency time deposits became again more attractive
than other alternatives. The subsiding inflation after 1994 allowed for a slight regain of
confidence by individual investors and the first investment funds were set up, even
before relevant legislation has been in place. The lack of prudential regulations allowed
in some instances for the flourishing of deceiving Ponzi schemes in the first half of the
1990s. Even some initially well reputed investment funds proved to be ill managed and
collapsed later, in 2000, losing thousands of investors their life savings (see the FNI
National Investment Fund case documented extensively in the Romanian press).
Under these circumstances, firm-level reforms were reduced to harsh liquidity
constraints, measures that are mistakenly identified with hardening budget constraints.
Restricting liquidity without enforcing consistently payment discipline (including here
payments to suppliers, bank creditors, and fiscal liabilities) can actually hinder financial
reforms by allowing for short-term innovations that do not eliminate cost inefficiency,
bad management and bad corporate governance, or non-profit maximising behaviour.
Credit and liquidity constraints affect indiscriminately viable and non-viable businesses,
or, even worse, create adverse selection effects artificially sustaining large loss-makers
and preventing new private firms from developing profitable investment projects (see
Berglf and Roland 1997 and 1998).
The aggregate data available on overdue bank debt and inter-enterprise arrears support
this conjecture. Unfortunately, aggregate data on tax arrears were not available, partly
because it is a phenomenon that has occurred to a larger extent after 1995
21
.
The financial crises in April 1997 (starting with the bankruptcy of two private
commercial banks and culminating in the beginning of bankruptcy procedures in 1999
for two more state-owned banks: Banca Agricola
22
and Bancorex) halted the explosion
of overdue credit of both state, and private firms that had begun in early 1996. (see
Graph 6) The most significant development since 1995 had been the increase in the
share of overdue debt of majority-privately owned businesses, which has since been
consistently higher than financial arrears of majority-state-owned companies (Graph 7).
As shown in Schaffer and Turley (1999), the latter have found a relatively softer
financing source in tax arrears to the national and social security budgets.
However, real inter-enterprise arrears, for which I have data only until 1995, do not
show signs of perpetual increase, which suggests that, if the IEA constitute or have

21
Schaffer and Turley (1999) estimate the overdue tax debts of Romanian firm (in an extensive database of 9000
companies) to 6.1% of the GDP in 1997. However, as they are stressing in the paper, it is not the stock of tax arrears
that is of primary concern, but the flow of arrears. That is because there are several reasons for which firms fall into
tax arrears, the chronic inability to pay (or, in their terminology, financial distress) being only one them.
22
A rescue package including a privatisation plan has been subsequently devised for Banca Agricola, but Bancorex
has been de facto declared bankrupt, its debt portfolio was taken over by AVAB a newly created debt recovering
agency and its deposits and retail operations were transferred to Banca Comercial! Romn! (BCR)
18
constituted a problem as a form of softening budget constraints, it can best be described
as a stock, and not as a flow problem. As shown in Croitoru and Schaffer (2000) for the
case of tax arrears, an increasing real gross arrears aggregate would be a sign that more
and more firms are running into arrears (or same firms are running higher arrears) since
the cost and risk of non-payment are low which is a proof of a weak institutional
framework for enforcement of commercial contracts. A constant level of aggregate real
arrears could be considered a sign of stabilising commercial practices, even if the total
stock of gross arrears in the economy may be considered large by international
standards.
The learning curve on which most Romanian firms have embarked since the early 1990s
has determined (even if with some delay) suppliers to halt deliveries to non-paying
customers, even if the search for new customers has prohibitively high costs. Instead,
state-owned (and even some privately-owned) firms have engaged in some new rent-
seeking activities, applying for rescue packages from the government
23
, for tax and bank
arrears rescheduling and, as a special case of relations to suppliers for the rescheduling
of debts to the state-owned providers of utilities.

23
Trade unions have been strong promoters of demands for government support in the case of the tractors and
agricultural machinery producers of Bucharest and Bra"ov, the mining companies of Valea Jiului or the steel
producers of Gala#i and Hunedoara. Even some newly privatized firms, whose new owners did not fulfill the
commitments stipulated in the privatisation contract, have initiated strikes demanding the government to intervene in
order to save the companies from imminent bankruptcy.
19
Graph 5
Real broad money without savings and time deposits in foreign currency (ReM2_dom) and savings
and demand deposits in foreign currency (ReForexdep) (in lei billion - deflated by the PPI)
199701
0
20
40
60
80
100
120
140
160
180
200
1
9
9
1
0
1
1
9
9
1
0
4
1
9
9
1
0
7
1
9
9
1
1
0
1
9
9
2
0
1
1
9
9
2
0
4
1
9
9
2
0
7
1
9
9
2
1
0
1
9
9
3
0
1
1
9
9
3
0
4
1
9
9
3
0
7
1
9
9
3
1
0
1
9
9
4
0
1
1
9
9
4
0
4
1
9
9
4
0
7
1
9
9
4
1
0
1
9
9
5
0
1
1
9
9
5
0
4
1
9
9
5
0
7
1
9
9
5
1
0
1
9
9
6
0
1
1
9
9
6
0
4
1
9
9
6
0
7
1
9
9
6
1
0
1
9
9
7
0
1
1
9
9
7
0
4
1
9
9
7
0
7
1
9
9
7
1
0
1
9
9
8
0
1
1
9
9
8
0
4
1
9
9
8
0
7
1
9
9
8
1
0
1
9
9
9
0
1
ReForexdep ReM2_dom
20
Graph 6
Real Overdue Bank Credit
199605
199705
199101
199112
0.0
500.0
1000.0
1500.0
2000.0
2500.0
3000.0
3500.0
4000.0
4500.0
1
9
9
1
0
1
1
9
9
1
0
4
1
9
9
1
0
7
1
9
9
1
1
0
1
9
9
2
0
1
1
9
9
2
0
4
1
9
9
2
0
7
1
9
9
2
1
0
1
9
9
3
0
1
1
9
9
3
0
4
1
9
9
3
0
7
1
9
9
3
1
0
1
9
9
4
0
1
1
9
9
4
0
4
1
9
9
4
0
7
1
9
9
4
1
0
1
9
9
5
0
1
1
9
9
5
0
4
1
9
9
5
0
7
1
9
9
5
1
0
1
9
9
6
0
1
1
9
9
6
0
4
1
9
9
6
0
7
1
9
9
6
1
0
1
9
9
7
0
1
1
9
9
7
0
4
1
9
9
7
0
7
1
9
9
7
1
0
1
9
9
8
0
1
1
9
9
8
0
4
1
9
9
8
0
7
1
9
9
8
1
0
1
9
9
9
0
1
Real overdue credit 12 per. Mov. Avg. (Real overdue credit)
21
Graph 7
Real overdue bank credit to majority state/privately owned enterprises
(lei million, deflated by the PPI)
199606
199705
199112
199101
199411
199704
0
500
1000
1500
2000
2500
3000
1
9
9
1
0
1
1
9
9
1
0
4
1
9
9
1
0
7
1
9
9
1
1
0
1
9
9
2
0
1
1
9
9
2
0
4
1
9
9
2
0
7
1
9
9
2
1
0
1
9
9
3
0
1
1
9
9
3
0
4
1
9
9
3
0
7
1
9
9
3
1
0
1
9
9
4
0
1
1
9
9
4
0
4
1
9
9
4
0
7
1
9
9
4
1
0
1
9
9
5
0
1
1
9
9
5
0
4
1
9
9
5
0
7
1
9
9
5
1
0
1
9
9
6
0
1
1
9
9
6
0
4
1
9
9
6
0
7
1
9
9
6
1
0
1
9
9
7
0
1
1
9
9
7
0
4
1
9
9
7
0
7
1
9
9
7
1
0
1
9
9
8
0
1
1
9
9
8
0
4
1
9
9
8
0
7
1
9
9
8
1
0
1
9
9
9
0
1
Realoverdue_SOE Realoverdue_POE
22
Graphs 8 and 9 present the evolution of gross aggregate inter-enterprise arrears, in
nominal and real form, in comparison with monthly annualised inflation (computed for
the PPI deflator). There is a contradictory relation between dynamics of real arrears and
inflation:
After the January 1992 arrears compensation exercise enacted by the Ministry of
Finance (with the participation of the NBR) (see Clifton and Khan 1993), even if arrears
rose quickly back to an apparently average level of about 100 billion lei (at 1990
prices) inflation subsided gradually throughout the first half of 1992. Between mid-
1992 and mid-1993 there appears to be a positive relation between inflation and real
arrears, while after June 1993 IEA and inflation start moving in opposite directions.
Without speculating too much on the behaviour of the two data series, we can safely
conclude, that, even if individual decisions of firms to run trade credit arrears (and the
size of these arrears) may well include inflationary expectations
24
, there are a wide range
of other factors determining the levels and dynamics of IEA. On the aggregate, the
compound effect of these individual decisions makes the evolution of real IEA over
time independent of the actual dynamic of inflation, and, as we will see in the following
section, of the actual aggregate demand for transaction balances.

24
The fact that suppliers form expectations about the general price level, as well as about the relative price of their
own products may also contribute to the decision to extend of trade credit to customers known to default or pay late
and especially to the heterogeneity of the pricing decisions of the respective deliveries.
23
Graph 8
Gross nominal arrears and PPI inflation
0
2000
4000
6000
8000
10000
12000
14000
1
9
9
1
0
1
1
9
9
1
0
3
1
9
9
1
0
5
1
9
9
1
0
7
1
9
9
1
0
9
1
9
9
1
1
1
1
9
9
2
0
1
1
9
9
2
0
3
1
9
9
2
0
5
1
9
9
2
0
7
1
9
9
2
0
9
1
9
9
2
1
1
1
9
9
3
0
1
1
9
9
3
0
3
1
9
9
3
0
5
1
9
9
3
0
7
1
9
9
3
0
9
1
9
9
3
1
1
1
9
9
4
0
1
1
9
9
4
0
3
1
9
9
4
0
5
1
9
9
4
0
7
1
9
9
4
0
9
1
9
9
4
1
1
1
9
9
5
0
1
1
9
9
5
0
3
1
9
9
5
0
5
l
e
i

b
i
l
l
i
o
n
s

(
c
u
r
r
e
n
t

p
r
i
c
e
s
)
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
%

a
n
n
u
a
l
i
z
e
d

i
n
f
l
a
t
i
o
n
ARRS INFLPPI
24
Graph 9
Gross real aggregate arrears (1991-1995) and PPI inflation
199201
199306
199207 y =-0.7853x +131.48
R
2
=0.0889
0
50
100
150
200
250
1
9
9
1
0
1
1
9
9
1
0
3
1
9
9
1
0
5
1
9
9
1
0
7
1
9
9
1
0
9
1
9
9
1
1
1
1
9
9
2
0
1
1
9
9
2
0
3
1
9
9
2
0
5
1
9
9
2
0
7
1
9
9
2
0
9
1
9
9
2
1
1
1
9
9
3
0
1
1
9
9
3
0
3
1
9
9
3
0
5
1
9
9
3
0
7
1
9
9
3
0
9
1
9
9
3
1
1
1
9
9
4
0
1
1
9
9
4
0
3
1
9
9
4
0
5
1
9
9
4
0
7
1
9
9
4
0
9
1
9
9
4
1
1
1
9
9
5
0
1
1
9
9
5
0
3
1
9
9
5
0
5
l
e
i

b
i
l
l
i
o
n

(
1
9
9
0

p
r
i
c
e
s
)
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
%

a
n
n
u
a
l
i
z
e
d

i
n
f
l
a
t
i
o
n
RARRS INFLPPI linear trend for RARRS
25
See also: http://www.som.hw.ac.uk/cert/wpa/2001/Graph9(b).xls
Gross real aggregate arrears (1991-1995)
y =0.0746x
2
- 4.8127x +168.4
R
2
=0.2388
0
50
100
150
200
250
1
9
9
1
0
1
1
9
9
1
0
3
1
9
9
1
0
5
1
9
9
1
0
7
1
9
9
1
0
9
1
9
9
1
1
1
1
9
9
2
0
1
1
9
9
2
0
3
1
9
9
2
0
5
1
9
9
2
0
7
1
9
9
2
0
9
1
9
9
2
1
1
1
9
9
3
0
1
1
9
9
3
0
3
1
9
9
3
0
5
1
9
9
3
0
7
1
9
9
3
0
9
1
9
9
3
1
1
1
9
9
4
0
1
1
9
9
4
0
3
1
9
9
4
0
5
1
9
9
4
0
7
1
9
9
4
0
9
1
9
9
4
1
1
1
9
9
5
0
1
1
9
9
5
0
3
1
9
9
5
0
5
l
e
i

b
i
l
l
i
o
n
,

c
o
n
s
t
a
n
t

1
9
9
0

p
r
i
c
e
s
RARRS Poly. (RARRS)
26
4. IEA as determinants of money velocities
The comparative analysis of M1 and M2 velocities and their determinants provide an
indirect view on monetary aggregates behaviour. In times of structural turmoil and
major economic and financial reforms (even if incomplete) in a TE such as Romania,
money velocity can hardly be considered a constant. As seen in Graph 10 the velocities
of different monetary aggregates (including quasi-money designated by QM) have a
contradictory behaviour between 1991 and 1995, for which an estimated monthly GDP
series was available from the National Commission for Statistics. It clearly points out
the higher velocity of QM until late 1993 and, thereafter, an increase in M1 and a
decrease in QM velocities, which keeps the velocity of M2 fairly constant between June
1993 and the end of 1994. During 1994 the central bank authorities take a turn towards
tighter monetary policies, accompanied by an end-of-the-year adjustment of the money
supply (Dec. 1994). This date also marks the beginning of a slow decline in all three
velocity variables.
27
Graph 10
Money aggregates velocity
199502
199412
199404
199212
199311
199205
199111
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
1
9
9
1
0
1
1
9
9
1
0
3
1
9
9
1
0
5
1
9
9
1
0
7
1
9
9
1
0
9
1
9
9
1
1
1
1
9
9
2
0
1
1
9
9
2
0
3
1
9
9
2
0
5
1
9
9
2
0
7
1
9
9
2
0
9
1
9
9
2
1
1
1
9
9
3
0
1
1
9
9
3
0
3
1
9
9
3
0
5
1
9
9
3
0
7
1
9
9
3
0
9
1
9
9
3
1
1
1
9
9
4
0
1
1
9
9
4
0
3
1
9
9
4
0
5
1
9
9
4
0
7
1
9
9
4
0
9
1
9
9
4
1
1
1
9
9
5
0
1
1
9
9
5
0
3
1
9
9
5
0
5
1
9
9
5
0
7
1
9
9
5
0
9
1
9
9
5
1
1
VM1 (monthlyGDP/M1) VQM(monthlyGDP/QM) VM2 (monthlyGDP/M2)
28
4.1 An empirical approach to testing the impact of IEA on M1 and M2 velocity
Since a higher money velocity could be considered a sign of increasing monetary
transactions and a diversification in the availability of financial instruments, hence, a
relaxation of financial repression, (Chang 1994), but can also be a result of confidence
erosion in the national currency due to high inflation (Anderson and Citrin 1995, Calvo
and Kumar 1994), I have tried to determine which variables that would connect to the
financial developments in the economy would most influence money velocity, and
whether there are any significant differences between the impact of variables on M1 and
M2 velocities, respectively. The summary of a few empirical estimates are presented in
Tables 1 and 2 below.
The inclusion of interenterprise arrears as one of these determinants is also meant to test
the impact of the monetary substitution
25
function that IEA is supposed to perform at the
macroeconomic level. (Lahiri and Citrin 1995)
Assume that the money supply equals the active demand for cash M
T
, and circulating
at velocity v
T
, assumed constant, plus an idle money holdings (arrears) component
M
0
, with zero velocity
26
. Therefore:
(a)
T
M M M + =
0
; and
(b)
M
v M
v v M v M M v M v M Mv
T T
T T T T T T
= = + = + = 0
0 0 0
Since M
T
< M, the total (actual) velocity is smaller than the transaction money demand
(measured) velocity. Therefore the increase in velocity observed in the case of TEs
(particular in the Anderson and Citrin 1994 study on states of the former Soviet Union)
may be the consequence of the unaccounted for arrears component in broad money
supply. In the case of our study on Romania, the inclusion of arrears on the right hand
side of the econometric estimation of M1 and M2 velocity should be significant only if
the currency substitution role of arrears has a significant hindrance effect on money
supply policies. If arrears are increasing, the gap between M
T
and M is increasing, so,
even if total money velocity is constant, transaction money (measured) velocity will
appear to be increasing (positive correlation).
The main determinants of money velocity are the ratio of quasi money to M1 and real
non-government credit, with the first order autocorrelation coefficient and the dummy

25
The influence of monetary substitution into foreign currencies (dollarization) on velocity is explored in Dobrescu
1994, Sahay and Vegh 1995
26
Although, admittedly, the assumption of 0 velocity for the M
0
component of M is rather extreme since there is
actually an initial transaction that arrears have been used for it is meant to emphasize the fact that arrears do not
serve the transaction function as normal trade credit does, although even then, to a limited extent. Once incurred,
overdue credit cannot be transformed back into actual money unless some kind of action is taken in order to force
the debtor to pay the arrears.
29
variable for the turn in monetary policy attitude in 1994 having also significant
coefficients.
A highly unstable economic environment reduces the demand for transaction (non-
interest-earning) money balances more rapidly than the demand for quasi-money
(especially if foreign currency deposits are included), determining a raise in the
QM/M1
27
ratio and an increase in both M1 and M2 velocities. On the other hand, a
subsiding inflation rate would increase the confidence of the money holders in the
currency and the demand for transaction money increases faster than the demand for
interest-earning assets (again, because savers may, in part, simply switch from foreign
exchange-denominated deposits to domestic currency-denominated assets, without any
effect on the QM aggregate), thus reducing the QM/M1 ratio. This would also lead to a
decrease in the money velocity, as is reflected in the positive relationship between the
QM/M1 ratio and both velocities in our empirical estimations. Moreover, the evolution
of the QM/M1 ratio has a stronger influence on M1 velocity, as would be expected,
since transaction money balances are more sensitive to short-term changes in economic
environment, which would be the case with monthly data. Since this ratio accounts for
the effect of the uncertainty at the macroeconomic level, adding an inflation variable
(measured either by PPI or CPI) to the model does not add any explanatory power, and
the coefficients of the inflation variables are always found non-significant.
The increase in real non-government credit taken, again as an indicator of financial
deepening and increased confidence in the business opportunities in the economy has
a strong negative effect on both M1 and M2 velocities, which confirms the hypothesis of
Anderson and Citrin (1995) that declining money velocities are a strong sign of recovery
and positive consequences of reforms in transition economies. The relevance of the
RNGC variable as determinant of M1 and M2 velocity should be, however, regarded
with caution, because both aggregate credit and velocity could be influenced by
economic instability in the economy and their relation could be one of simultaneous
reaction to changing inflation and negative growth rather than a causality relation.
The influence of real public debt (as an instrument of fiscal policy) on money velocity in
the period 1991-1995 in Romania is still very weak, partly because the non-monetary
instruments of financing the budget deficit have only started to be developed after 1996,
and seignorage revenues from inflation started to be replaced by bond financing. Even
if non-significant, the real public debt variable has a negative coefficient, which
confirms the fact that higher real public debt is consistent with later stages of financial
development (when proper debt financing instruments become more popular) and
money velocity is expected to decline.

27
I used this ratio as a proxy for a component of financial deepening, since an increase in financial intermediation
(see page 6 and footnote 9) would decrease QM and increase or leave M1 unchanged, which will unambiguously
decrease their ratio. This, however, would imply a negative relationship between QM/M1 and M2 velocity and a non-
significant relationship between QM/M1 and M1 velocity. This is not the case in our analysis, where inflation is a
stronger determinant of portfolio decisions between transaction and precautionary/speculative balances and a positive
relation between the QM/M1 ratio and both velocities is more probable.
30
Although small, the impact of an increase in real interest rates on velocity is also
negative, which is consistent with the expectation that positive (and higher) interest
rates are one of the main contributors to eliminating financial repression (see McKinnon
1993). The hypothesis that a tighter monetary policy stance is also conducive to lower
velocity and can contribute decisively to financial deepening is also supported by the
negative and significant coefficient of the dummy variable for 1994, the year of a
notable turn towards restrictive money supply policies undertaken by the NBR.
Since the inflation variables do not add explanatory power to the estimations (and may
even introduce), I have tried to replace them by lagged values, to account for (adaptive)
inflationary expectations, rather than actual inflation. The lagged inflation variable
determines significantly money velocity, but, surprisingly, the relation is negative. It
may be possible that the combined effect of: (1) lower output caused by the expectations
of higher uncertainty; and (2) higher money demand to account for the price increases;
dominates the flight from money effect of higher inflation and the efforts of tight
monetary policies resulting in velocity decreasing, rather than increasing with
increasing inflationary expectations. However, it is hard to explain this occurrence
without launching to some degree in pure speculation.
31
Table 1
VM1 equations
Independent
variables
1 2 3 4 5 6 7 8 9 10 11 12
AR(1) 0.481 0.420 0.435 0.767 0.774 0.879 0.523 0.479 0.471 0.616 0.646 0.669
QM/M1 1.347 1.575 1.380 1.867 1.860 1.759 1.587 1.323 1.577 1.524 1.494 1.422
RCOMB_IR_L ------ -0.002 -0.002* -0.006 -0.006 -0.004 -0.002 -0.002 -0.002 -0.002 -0.001* ------
PPIINFL ------ ------ ------ ------ 0.114* 0.266* 0.109* ------ ------ ------ ------ ------
PPIINFL(t-1) ------ ------ ------ ------ ------ ------ ------ ------ -0.312 -0.282 ------ ------
CPIINFL ------ ------ ------ ------ ------ ------ ------ 0.173* ------ ------ ------ ------
RNGC -0.863 -0.841 -0.795 ------ ------ ------ -0.754 -0.612 -0.792 -0.759 -0.750 -0.716
RARREARS ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ 0.034* 0.036
RPUBDEBT ------ ------ -0.059* -0.059* -0.049* ------ ------ ------ ------ ------ ------ ------
AR(9) -0.227 -0.291 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------
DUM ------ ------ ------ ------ ------ ------ ------ ------ ------ -0.199 -0.203 -0.209
Constant 2.569 2.510 2.314 2.131 2.173 2.375 2.492 2.553 2.509 2.522 2.535 2.567
Adj. R-squared 0.987 0.990 0.986 0.981 0.981 0.981 0.986 0.989 0.987 0.990 0.990 0.990
DW statistic 1.804 1.733 1.905 2.097 2.087 2.188 1.902 2.103 1.896 1.758 1.853 1.847
* Not significant at conventional significance levels (1%, 5%, 10%)
a
only significant at 10% significance level
Notes: all variables are monthly data and, except interest rate, are in log form
constants reflect the fact that the AR term is considered applied to the error term, not the lagged dependent variable. The transformation to the constant in an
equation with the lagged dependent variable is c = constant(1-!) where ! is the AR(1) coefficient
32
Table 2
VM2 equations
Independent
variables
1 2 3 4 5 6 7 8 9 10 11 12
AR(1) 0.507 0.398 0.465 0.794 0.798 0.881 0.528 0.324 0.480 0.621 0.647 0.704
QM/M1 0.232 0.487 0.405 0.849 0.846 0.745 0.595 0.295 0.589 0.532 0.497 0.389
RCOMB_IR_L ------ -0.002 -0.002
a
-0.006 -0.006 -0.004
a
-0.003 -0.003 -0.003 -0.003 -0.002* ------
PPIINFL ------ ------ ------ ------ 0.054* 0.188* 0.093* ------ ------ ------ ------ ------
PPIINFL(t-1) ------ ------ ------ ------ ------ ------ ------ ------ -0.305 -0.275 ------ ------
CPIINFL ------ ------ ------ ------ ------ ------ ------ 0.096* ------ ------ ------ ------
RNGC -0.945 -0.912 -0.846 ------ ------ ------ -0.767 -0.647 -0.804 -0.760 -0.750 -0.695
RARREARS ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ 0.036
a
0.040
a
RPUBDEBT ------ ------ -0.041* -0.042* -0.034* ------ ------ ------ ------ ------ ------ ------
AR(9) -0.180
a
-0.269 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------
DUM ------ ------ ------ ------ ------ ------ ------ ------ ------ -0.183 -0.188 -0.195
Constant 1.856 1.790 1.641 1.458 1.477 1.644 1.753 1.827 1.768 1.782 1.800 1.847
Adj. R-squared 0.915 0.9200 0.912 0.881 0.879 0.917 0.939 0.959 0.937 0.950 0.960 0.959
DW statistic 1.83 1.67 1.87 2.06 2.06 2.12 1.88 2.06 1.88 1.74 1.81 1.79
* Not significant at conventional significance levels (1%, 5%, 10%)
a
only significant at 10% significance level
Note: all variables are monthly data and, except interest rate, are in log form
constants reflect the fact that the AR term is considered applied to the error term, not the lagged dependent variable. The transformation to the constant in an
equation with the lagged dependent variable is c = constant(1-!) where ! is the AR(1) coefficient
33
Legend: AR(1) = first order autocorrelation coefficient
QM/M1 = the ratio of quasi-money to M1
RCOMB_IR_L = real average commercial bank lending rate (inflation measured by the PPI)
PPIINFL = inflation measured by the change in PPI
PPIINFL(-1) = first lag of inflation measured by the change in PPI
CPIINFL = first lag of inflation measured by the change in CPI
RNGC = real total non-government credit in the economy, deflated by the PPI (CPI in the CPI
equations)
RARREARS = real gross inter-enterprise arrears, deflated by the PPI (CPI in the CPI
equations)
RPUBDEBT = real public debt, deflated by the PPI (CPI in the CPI equations)
DUM = dummy variable equal to 1 for December 1994, the date of the monetary aggregates
readjustment.
Turning now towards the main focus of our empirical investigation, the sign of the real
gross arrears variable is consistent with the theoretical assumptions presented above, but
is, however, very low and only significant at 10% (or 20%, in one case) confidence
level, for both specifications of the dependent velocity variable
That indicates that the hypothesis of some authors (Lahiri and Citrin (1995), Clifton and
Khan (1993), Amrit-Poser(1996)) and the dominant belief of Romanian policy-makers
in the period under analysis that the IEA interfered with the monetary transmission
mechanism by affecting the firms demand for transaction balances, are not supported
by the data
28
.
These empirical models are an ad-hoc method to test the influence of overdue trade
credit (IEA) on the M1 and M2 velocity variables in a transition economies. In the next
part of this Section I will try a more theoretical approach, using a simple money demand
- money supply model.
4.2. A theoretical approach to testing the influence of IEA on money velocity.
A gap between the dynamic of v
M1
and that of v
M2
according to Zahn and Hosek
(1973) is indicative of a higher influence of TC and IEA on v
M1
, since both are
transaction money substitutes but not stores of wealth. If the increase in velocity would
be due to increased financial intermediation, then the M2 velocity would increase more
than M1 velocity, since new financing sources will be more likely to replace less

28
I am grateful to Prof. Dobrescu for pointing out that these results may be significantly influenced by the choice of
the sample period. In his own research he finds a more significant causal relation between the gross real arrears
aggregate and both M1 and M2 velocity, by using a data set extending to December 1996. He also suggests that
using net arrears instead of gross arrears would make for a more accurate analysis. Unfortunately, no data on net real
arrears are available for Romania at the aggregate level.
34
money-like savings instruments
29
. This, however, was not the case in Romania in the
1991-1995 period, when the erratic evolution of both money velocities was lead by the
higher increase in M1 velocity, up to 1994. After 1994, there is a gradual decrease of
both velocities, due to tighter monetary policies which succeeded temporarily to reduce
inflation by means of high nominal (and positive real) interest rates.
Following the idea used by Laffer (1970) and Zahn and Hosek (1973) I try to estimate a
simple M
s
-M
d
model with and without IEA as determinant of total money demand and
track the influence it has on estimated M1 and M2 velocities. The two models (with and
without the inclusion of arrears) are then tested for their predictive abilities and
compared. If the model including the arrears variable is better at predicting the dynamic
of observed velocity of M1 (but not of M2), we may conclude that IEA could act as a
substitute for transaction money and represents a perverse financial innovation in
transition economies, interfering with the effectiveness of anti-inflationary monetary
policies.
Zahn and Hoseks model specification:
(where R is the market rate of interest, Y
p
is permanent income, HP is high-powered
money, Y is current national income and M is the equilibrium money stock) is not
entirely appropriate for the case of Romania, as a TE. One reason is the reduced
significance of the permanent income concept in times of high uncertainty generated
by price instability and the hectic pace of transition reforms. Another factor is the high
impact of inflationary expectations, as well as the influence of actual and expected
government policies on the demand for money. Also, the Zahn and Hosek model is
devised for the large (quasi-closed) economy of the US, while Romania is a small open
economy, whose money market is widely exposed to the influence of the exchange rate
dynamics in the period under consideration. Therefore, the specification of the M
d
and
M
s
functions have to be adapted accordingly:

29
see footnote 9
) 4 (
) 3 (
) 2 ( ) , (
) 1 ( ) , (
M
Y
v
M M M
HP R f M
Y R f M
d s
s
p d
=
= =
=
=
)' 4 (
)' 3 (
)' 2 ( ) , (
)' 1 ( ) , , (
M
Y
v
M M M
X f M
y R f M
d s
e s
d
=
= =
=
=
35
where y stands for real GDP, R for the commercial interest rate, $ for inflation, $
e
for
expected inflation and X for other exogenous variables, and v is the velocity of M.(all
variables are in log real terms, deflated by the PPI, and is PPI annual inflation). The
endogenous variables are M
d
, M
s
and v, while, $, $
e
, y, R, X (which in our model is
represented by real non-government credit - as a proxy for perceived monetary tightness
not captured by the rigidity of the interest rate variable and/or the foreign exchange
depreciation rate) are considered exogenous. The money supply equation reflects a
simplified inflation-targeting rule. Even if Romanian monetary authorities (until at least
1996) did not explicitly follow such a rule, the main concern with reducing inflation
under all IMF-supported stabilisation programmes has fallen with the central bank. I
also consider a version of the model where the rate of foreign exchange depreciation is
another policy target included in the M
s
process. The 1991-1995 period in Romania has
also been marked by the effort of the monetary authorities to prevent the over-
depreciation of the national currency considered the most important determinant of
inflation dynamics but also to prevent a strong real appreciation of the national
currency that would hinder exports, vital for keeping the balance payments deficit under
control.
Three dummy variables have been used to mark discontinuity moments in the period,
represented by the liberalisation of foreign exchange transactions November 1991
(DUM1), the monetary policy adjustment since 1994 (DUM2)
30
and the first arrears
compensation exercise at the beginning of 1992 (DUM3).
In the first instance I estimate the empirical M
s
and M
d
system without accounting for
the overdue inter-enterprise debt component (Models 1 to 6 in Table 3).
Next, Zahn and Hosek re-compute the model by adding a variable capturing the
influence of TC, as exogenous determinant in the money demand equation (1), the other
equations remaining the same. Zahn and Hosek find that the second model, made up of
equations (5)-(8), has a better performance, in terms of the predicted money velocity
over the sample period.
I apply the same idea, using real gross inter-enterprise arrears (RARRS), but I include a
separate equation in the model, making the arrears variable endogenous.

30
The political pressure on the governance of the NBR to finance sectors in crisis (e.g. agriculture, state-owned
banking sector) was high during the period 1991-1995, so I attempted to test if the model reveals a significant change
of attitude since 1994 by the introduction of this dummy variable.
) 8 (
) 7 (
) 6 ( ) , (
) 5 ( ) , , (
M
Y
v
M M M
HP R f M
TC Y R f M
d s
s
p d
=
= =
=
=
36
Given the theoretical priors (see Crawford 1992b), the real inter-enterprise arrears
should depend on a scale variable (for which I use LRGDP real GDP) and on the
holdings of transaction money in the previous period (lagged real money LRM(-1))
(equation (8)). The opportunity cost variable (interest rate) is not a significant
determinant of the demand (and supply) for inter-enterprise debt (much less for arrears)
during this period in Romania, given the non-price rationing of bank credit and the little
choice available to firms in terms of alternative financing sources.
31
Models 1a to 6a estimate the system (5)-(9) under the respective specifications used
for models 1 to 6 in Table 3.
In equation (5), we would expect the increase in real GDP (y) to have a positive impact
on money demand, while the increase in interest rate (R), inflation ("), and real arrears
(ARRS) to have a negative impact. Also, money holders would tend to reduce their
demand for national currency denominated money balances if its rate of depreciation
increases (LFOREXDEPR in models 4, 4a, 5 and 5a). In the money supply equation
(6) we expect the coefficient of the expected inflation
32
variable to be negative, and the
coefficients of the real non-government credit, interest rate, and nominal exchange rate
depreciation rate variables to be positive. Finally, the real arrears would be directly
proportional to an increase in real GDP (as a measure of the aggregate volume of
commercial transaction in the economy) and inversely related to the holdings of money
in the previous period, as an indication of liquidity availability to firms using TC
(Crawford 1992b) and/or resorting to arrears as substitute for transaction balances.
The actual estimation process of systems (1)-(4) and (5)-(9) raised a few
computational problems: First, the real money variable appears to be non-stationary for
the period 1991-1995, according to traditionally-used unit root tests (Augmented
Dickey-Fuller and Phillips-Perron). The low power of these tests is a widely debated
issue in the technical econometrics literature (see Campbell and Perron 1991, Enders
1995) therefore we cannot be sure that the real money (LRM1) series is really non-
stationary or it just has a very high AR coefficient (0.86 in a simple AR setting with a

31
After 1995 tax arrears and arrears to the state-owned utilities monopolies, became a much more significant
alternative financing source, as a form of implicit subsidy from the government similar to the developments in
Russia described in Pinto, Debrentsov and Morozov (2000)
32
To account for the short-term nature of the model (since I am using monthly data) and for the lag in the monetary
transmission mechanism I use the third lag of inflation as independent variable in the M
s
equation. This would mean
that the monetary authority makes its decisions based on adaptive expectations for inflation using data of the previous
quarter. It is, however, significant that official NBR and Government forecasts for annual inflation in the 1990s have
systematically been below the actual rates.
)' 9 (
)' 8 ( ) ), 1 ( (
)' 7 (
)' 6 ( ) , (
)' 5 ( ) , , , (
M
Y
v
y M f ARRS
M M M
X f M
ARRS y R f M
d s
e s
d
=
=
= =
=
=
37
deterministic trend, 0.92 in a model with dummy variables and no deterministic trend,
and 0.88 in an ARMA(1,1) model including a deterministic trend and dummy
variables)
33
. There is usually no pertinent explanation for the fact that real money is
non-stationary, other than the case of countries with hyperinflation. Even if Romania
did not experience the extreme conditions of a typical hyperinflation, the period under
consideration does include the years with the highest average inflation of the decade
(1991 320.1% for the PPI inflation and 1993 356.1% for the CPI inflation) and is a
period of reduced confidence in the national currency, due to negative real interest rates
and the rapid devaluation of the Leu. This is also the reason why the log-inflation
variable has a high AR coefficient (0.88 in an ARMA(1,1) model including a
deterministic trend and dummy variables). The log arrears variable is an ARMA(1,1)
process with a 0.53 AR coefficient and a 0.70 MA coefficient.
Given these theoretical considerations I have estimated the model in levels, including
autoregressive terms
34
, which would also account for the short-term adjustment process
to the long-term money market equilibrium. I have done the estimation in reduced
form, with the system consisting of the first two equations (three equations when real
arrears are included). The estimation of the M
s
-M
d
system was done by two-stage least
squares, which is the appropriate estimation method, given that both equations in the
system are over-identified. The instruments used are: (i) real GDP (LRGDP), (ii) real
average commercial banks lending rate (LREALCOMBIR), (iii) inflation (LINFL) and
lagged inflation (LINFL(-3)) variables; (iv) real non-government credit (LRNGC), to
account for the degree of tightness of monetary policy and, finally, (v) the foreign
exchange depreciation rate (LFOREXDEPR)
35
.
The results of these estimations for the narrow real money variable (LRM1) are
presented in Table 3, including the values for % the autocorrelation coefficient. Table
4 presents the results of the same estimations for the broad real money variable (LRM2).
The second computational problem is the high level of correlation between inflation and
the real interest rate. That could be explained by the high level of rigidity of nominal
interest rates during this period, so that the dynamic of the real interest rate mimics
closely the dynamic of inflation. That is a symptom of early financial liberalisation
stages, when the commercial banking system still dominated by the state-owned banks
sets the lending and deposit rates by rigid mark-ups over the central bank rates
(refinancing or reserve deposit rates) due to their inability to estimate deposit and
lending risks in the unstable general economic environment. Therefore, Model 1 and
Model 1a, including LOGREALCOMBIR as endogenous, and LINFL as exogenous
variables are subject to multicollinearity for the sample used in the analysis, which casts

33
The LRM2 variable has an AR coefficient of 0.91 and no deterministic trend, in an AR model with dummy
variables.
34
I have also estimated the system in first difference form. The results are not presented here, but are available from
the author on request. The final conclusion is the same as the one resulting from the levels estimation, presented
below, but the goodness of fit is much lower.
35
Computed as percentage rate of monthly change in the nominal average exchange rate in lei/US dollar
38
serious doubts upon the relevance of the resulting regression coefficients
36
. Dropping
LOGREALCOMBIR from the right hand side of the equations reduces the standard
errors of the other coefficients, which is a clear indication of multicollinearity.
Although detrimental for the theoretical coherence of the model, we have to drop the
interest rate variable from the model.
Models 2 and 2a estimate the M
s
-M
d
system without the interest rate variable and
assuming inflation is exogenous. Models 3 and 3a assume inflation is endogenous,
without, however, changing much the coefficient estimates and their significance.
Models 3 and 3a also introduce the DUM2 dummy variable in the money demand
equation to account for the money holders response to the change in the attitude of the
monetary authorities during 1994, that allowed for commercial deposit interest rates to
become positive in real terms. As expected, the effect of the turn towards tighter
monetary policies on the demand for transaction money (M1) is negative, but is not
significant in the case of the demand for M2, since positive real interest rates shifted the
money balances kept under the mattress and/or in foreign currencies into term bank
deposits.
Models 4 and 4a introduce the rate of depreciation of the nominal exchange rate as
determinant in both money demand and money supply equation, keeping the previous
independent variables in the model. Since the expected inflation variable (meant to
account for a possible inflation targeting rule in the money supply process) proved to be
non-significant (and with the opposite sign than the one expected) in all previous
specifications, models 5 and 5a recompute the system eliminating the lagged inflation
variable from the money supply equation. Models 6 and 6a are a version of model 5 and
5a eliminating the exchange rate depreciation rate from the money demand equation.
This minor change increases the sample by one observation for the money demand
equation, which has a greater than expected effect both on the respective equation and
on the real arrears equation (8) in model 6a.

36
Making the interest rate variable exogenous changes somewhat the size and standard errors of the coefficients, but
not their sign and significance, with the exception of the interest rate coefficient in the demand equation, which
becomes non-significant at conventional levels. The standard error of the coefficients in the demand equation
remains high.
39
Table 3 Results of 2SLS estimations for models 1-6 and 1a-6a (LRM1 log real money M1 as dependent variable)
Equation Con-
stant
LINFL LFOREX
DEPR
LRM1
(-1)
LINFL
(-3)
LRGDP LREAL-
COMBIR
LRNGC DUM1 DUM2 DUM3 DUM3
(-1)
LRARRS !-coeff. Adj. R
squared
DW
Model 1
M
S
-1.525 0.125 -0.056 0.957* 0.861* 0.948 2.23
M
d
5.310* -0.756* -0.017 -0.522* 0.954* 0.918 2.12
Model 1a
M
S
-1.403 0.129 -0.038 0.946* 0.865* 0.948 2.22
M
d
5.890* -0.412 -0.106 -0.088 0.022 0.963* 0.923 2.10
LRARRS
37
3.077 0.100 0.188 -2.600* -0.842* 0.891* 0.917 1.34
Model 2
M
S
-1.091 0.133 0.916* 0.878* 0.949 2.21
M
d
5.571* -0.286* -0.072 0.960* 0.924 2.07
Model 2a
M
S
-1.091 0.133 0.916* 0.878* 0.949 2.21
M
d
5.940* -0.332* -0.116 0.022 0.963* 0.924 2.09
LRARRS
3.077 0.100 0.188 -2.596* -0.842* 0.891* 0.917 1.34
Model 3
38
M
S
-1.091 0.133 0.916* 0.878* 0.949 2.21
M
d
7.773* -0.534* -0.180 -0.237* 0.956* 0.928 1.86
Model 3a
M
S
-1.091 0.133 0.916* 0.878* 0.949 2.21
M
d
8.830* -0.683* -0.286 -0.239* 0.048** 0.967* 0.926 1.85
LRARRS
3.077 0.100 0.188 -2.596* -0.842* 0.891* 0.917 1.34
Model 4
M
S
-2.173* 0.101* 0.142 1.036* 0.857* 0.954 2.01
M
d
6.619* -0.295* 0.052 -0.210 -0.251* 0.933* 0.934 1.87
Model 4a
M
S
-2.173* 0.101* 0.142 1.036* 0.857* 0.954 2.02
M
d
7.278* -0.362* 0.062 -0.290 -0.255* 0.032 0.938* 0.936 1.87
LRARRS
3.077 0.100 0.188 -2.596* -0.842* 0.891* 0.917 1.34

37
The time series dynamic for LRARRS is actually an ARMA(1,1) process, but the 2SLS procedure computationally available can only allow for autocorrelation corrections with an AR term. The coefficients
of the LRARRS equation may, therefore, be biased and inconsistent.
38
In model 3 and 3a I have tried to endogenise the inflation variable, but, as it can be seen, the results do not change significantly from the model with exogenous inflation.
40
Table 3 (continued)
Equation Con-
stant
LINFL LFOREX
DEPR
LRM1
(-1)
LINFL
(-3)
LRGDP LREAL-
COMBIR
LRNGC DUM1 DUM2 DUM3 DUM3
(-1)
LRARRS !-coeff. Adj. R
squared
DW
Model 5
M
S
-0406 0.070** 0.845* 0.932* 0.949 1.99
M
d
7.795* -0.279* -0.201* -0.229 0.385* -0.218* 0.934* 0.946 1.85
Model 5a
M
S
-0.406 0.070** 0.845* 0.932* 0.949 1.99
M
d
8.027* -0.304* -0.189** -0.262 0.372* -0.221* 0.012 0.934* 0.945 1.83
LRARRS
0.907 0.408** 0.347 -2.590* -0.852* 0.788* 0.886 1.18
Model 6
M
S
-0.406 0.070** 0.845* 0.932* 0.949 1.99
M
d
6.998* -0.290* -0.238 0.132* -0.243* 0.944* 0.941 1.90
Model 6a
M
S
-0.406 0.070** 0.845* 0.932* 0.949 1.99
M
d
6.442* -0.356* -0.219 0.125** 0.106** 0.031 0.972* 0.919 2.15
LRARRS
0.907 0.408** 0.347 -2.590* -0.852* 0.788* 0.886 1.18
Notes: * significant at confidence 5% level
** significant at 10% confidence level
41
Table 4 Results of 2SLS estimations for models 1-6 and 1a-6a (LRM2 log real money M2 as dependent variable)
Equation Con-
stant
LINFL LFOREX
DEPR
LRM2
(-1)
LINFL
(-3)
LRGDP LREAL-
COMBIR
LRNGC DUM1 DUM2 DUM3 DUM3
(-1)
LRARRS !-coeff. Adj. R
squared
DW
Model 1
M2
S
1.329* -0.012 0.205* 0.935* 0.409* 0.957 2.10
M2
d
3.799* -1.457* 0.343** -1.319* 0.671* 0.864 1.89
Model 1a
M2
S
1.344* -0.017 0.198* 0.931* 0.412* 0.957 2.11
M2
d
5.860* -0.603* 0.117 -0.229 0.020 0.906* 0.921 2.25
LRARRS
39
2.253 0.293 0.168 -2.583* -0.832* 0.871* 0.919 1.39
Model 2
M2
S
1.552* -0.131* 0.809* 0.675* 0.947 2.34
M2
d
5.658* -0.362* 0.134 0.912* 0.920 2.18
Model 2a
M2
S
1.552* -0.131* 0.809* 0.675* 0.947 2.34
M2
d
6.062* -0.404* 0.088 0.022 0.916* 0.924 2.21
LRARRS
2.253 0.293 0.168 -2.583* -0.832* 0.871* 0.919 1.39
Model 3
40

M2
S
1.552* -0.131* 0.809* 0.675* 0.947 2.34
M2
d
5.818* -0.372* 0.123 -0.052 0.907* 0.920 2.09
Model 3a
M2
S
1.552* -0.131* 0.809* 0.675* 0.947 2.34
M2
d
6.402* -0.430* 0.057 -0.056 0.031 0.911* 0.925 2.12
LRARRS
2.253 0.293 0.168 -2.583* -0.832* 0.871* 0.919 1.39
Model 4
M2
S
0.394 0.104* -0.088 0.904* 0.815* 0.962 2.21
M2
d
6.550* -0.361* -0.111 0.075 0.222* 0.912* 0.926 2.21
Model 4a
M2
S
0.394 0.104* -0.088 0.904* 0.815* 0.962 2.21
M2
d
6.957* -0.409* -0.089 0.016 0.199* 0.024** 0.915* 0.929 2.19
LRARRS
2.253 0.293 0.168 -2.583* -0.832* 0.871* 0.919 1.39

39
The time series dynamic for LRARRS is actually an ARMA(1,1) process, but the 2SLS procedure computationally available can only allow for autocorrelation corrections with an AR term. The coefficients
of the LRARRS equation may, therefore, be biased and inconsistent.
40
In model 3 and 3a I have tried to endogenise the inflation variable, but, as it can be seen, the results do not change significantly from the model with exogenous inflation.
42
Table 4 (continued)
Equation Con-
stant
LINFL LFOREX
DEPR
LRM2
(-1)
LINFL
(-3)
LRGDP LREAL-
COMBIR
LRNGC DUM1 DUM2 DUM3 DUM3
(-1)
LRARRS !-coeff. Adj. R
squared
DW
Model 5
M2
S
0.140 0.089* 0.870* 0.920* 0.963 2.12
M2
d
6.568* -0.365* -0.103 0.073 0.211* -0.040 0.913* 0.935 2.14
Model 5a
M2
S
0.140 0.089* 0.870* 0.920* 0.963 2.12
M2
d
7.155* -0.428* -0.071 -0.012 0.179** -0.049 0.031 0.913* 0.940 2.09
LRARRS
-0.787 0.905* 0.201 -2.547* -0.821* 0.651* 0.900 1.33
Model 6
M2
S
0.140 0.089* 0.870* 0.920* 0.963 2.12
M2
d
6.089* -0.372* 0.077 0.081** -0.050 0.929* 0.939 2.09
Model 6a
M2
S
0.140 0.089* 0.870* 0.920* 0.963 2.12
M2
d
9.209* -0.556* -0.216 0.111 -0.883* 0.048 0.931* 0.689 1.62
LRARRS
-0.787 0.905* 0.201 -2.547* -0.821* 0.651* 0.900 1.33
Notes: * significant at confidence 5% level
** significant at 10% confidence level
1
Summarising the main results in Tables 3 and 4 we note that:
1. The aggregate real arrears variable is not a significant determinant of real money
demand in neither the M1 nor the M2 specification. This will also reflect in the
low impact of the inclusion of the IEA variable on velocity forecasts, as we will
see below. Moreover, the dynamics of the LRARRS seems to be mostly inertial,
practically independent of the evolution of the total transaction volume
(represented by the real GDP variable) and only marginally dependent on the
holdings of real money balances (only in models 5a an 6a LRM1(-1) has a
significant positive coefficient, and than only at 10% confidence level for the M1
aggregate).
41
However, the coefficient of the arrears variable in the money demand
equation is lower in the M2 systems than in the M1 systems, while money
holdings measured by M2 (including quasi-money) seems to have a somewhat
more significant influence on real gross IEA than the narrower, M1, measure. The
best description of the LRARRS dynamics is still an ARMA (1,1) process with a
dummy variable for the compensation exercise of 1992. We also note that the
lagged dummy variable has also a significant negative impact on the aggregate
gross arrears, showing that in expectation of the exercise firms did not try to
increase arrears, which goes against the moral hazard assumption of Clifton and
Khan (1993).
2. The hypothesis that the Romanian monetary authority followed some form of
inflation-targeting rule during 1991-1995 is not verified. The money supply
process is mostly driven by the non-government credit variable (only partly under
the control of the central bank) and by the concern for the over-depreciation of the
nominal exchange rate. In the M2 estimations the lagged inflation variable is
significant (and with the expected negative sign), but only as a consequence of the
exchange rate depreciation concern. This is clearly indicated by the fact that the
lagged inflation coefficient becomes non-significant once we control explicitly for
the rate of exchange rate depreciation in models 4 through 6.
3. The scale variable, represented by the real GDP variable is non-significant and has
the wrong sign in all model specifications. This could be caused by the short-term
nature of the model, by the low quality of the GDP monthly data, but also by the
strong influence of inflation and inflationary expectations in the money market,
which obscures the scale effect of real output. This hypothesis is supported by the
negative relation between inflation and growth (recession accompanied by
growing inflation), which has been common in the early stages of transition in
several countries (Calvo and Coricelli 1992).

41
Again, the main caveat for these conclusions is the time period available for the estimation. (see footnote 26) Once
the series is extended to the second half of the 1990s the results may vary, especially since the influence of the break-
up in the series caused by the 1992 IEA compensation exercise is diminished.
2
4. The rate of foreign exchange depreciation is a better determinant of money
supply than the inflation-targeting rule. When included in the money
demand equation (as a proxy for money-holders confidence in the national
currency) it increases the standard error of the inflation variable, which
indicates possible multicollinearity
42
. This is a plausible assumption since
currency depreciation is a very close proxy for money-holders inflationary
expectations in the high inflation environment of Romania during 1991-
1995.
Therefore, Models 6 and 6a look like the best choice for the empirical estimation of the
systems of equations (1)-(4) and (5)-(8), respectively. However, I have computed
dynamic forecasts for money demand velocity for all 6 versions of the model. In order
to compare the quality of the forecasts, I have computed the Theil inequality coefficients
(see Pindyck and Rubinfeld 1983) for the one, two, three, etc. - up to 24 steps ahead
forecasts
43
. The results are shown in Graphs 11 (a, b, and c) and 12 (a, b, and c). Note
that the Theil coefficient
44
takes values between 0 and 1 and the closest the coefficient is
to 0, the better the quality of the forecast. The series of 26 Theil coefficient values was
than compared pairwise for means between the respective models with and without
arrears (e.g. model 1 using M1 as dependent variable and no arrears equation with
model 1a using M1 as dependent variable and endogenous arrears in the system, etc.)
The results presented in Annex 1 suggest that the M
s
-M
d
systems that do NOT include
real arrears have a better (or at least an equally good) forecasting performance as the
models including the gross real IEA variable. Moreover, the same models using the M2
measure of money stock perform better than their counterparts using M1 as the measure

42
The multicollinearity effect may be enhanced by the presence of the DUM1 dummy variable, which accounts for
the November 1991 first stage of foreign exchange market liberalisation.
43
The usual practice is to forecast up to a maximum number of steps equal to 1/3 of the sample size. Here I have
gone a bit further than that, in order to cover two full years with the forecasts, so the further away in time, the less
reliable we would expect the forecast to be. In order to use the Theil coefficient I have only computed forecasts
inside the sample.
44
The Theil inequality coefficient, known also as Theils U coefficient is computed according to the formula:
,
) (
1
) (
1
) (
1
1
2
1
2
1
2
= =
=
+

=
T
t
a
t
T
t
f
t
T
t
a
t
f
t
Y
T
Y
T
Y Y
T
U where T is the number of periods in the forecast, Y
t
f
is the forecasted value
and Y
t
a
is the actual value.
3
for the money stock. (Graph 13). This is a crucial finding, revealing that - although the
inter-enterprise arrears have been the focus of a wide debate and the focus of most anti-
inflationary policy measures they do NOT represent a significant threat to the
effectiveness of monetary policies and do NOT influence significantly the demand and
supply for money and money velocity at the aggregate level, for the period under
analysis.
1
Graph 11a THEIL COEFFICIENTS FOR M1 MONEY DEMAND VELOCITY
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
1
9
9
5
:
0
5
-
1
9
9
5
:
0
5
1
9
9
5
:
0
4
-
1
9
9
5
:
0
5
1
9
9
5
:
0
3
-
1
9
9
5
:
0
5
1
9
9
5
:
0
2
-
1
9
9
5
:
0
5
1
9
9
5
:
0
1
-
1
9
9
5
:
0
5
1
9
9
4
:
1
2
-
1
9
9
5
:
0
5
1
9
9
4
:
1
1
-
1
9
9
5
:
0
5
1
9
9
4
:
1
0
-
1
9
9
5
:
0
5
1
9
9
4
:
0
9
-
1
9
9
5
:
0
5
1
9
9
4
:
0
8
-
1
9
9
5
:
0
5
1
9
9
4
:
0
7
-
1
9
9
5
:
0
5
1
9
9
4
:
0
6
-
1
9
9
5
:
0
5
1
9
9
4
:
0
5
-
1
9
9
5
:
0
5
1
9
9
4
:
0
4
-
1
9
9
5
:
0
5
1
9
9
4
:
0
3
-
1
9
9
5
:
0
5
1
9
9
4
:
0
2
-
1
9
9
5
:
0
5
1
9
9
4
:
0
1
-
1
9
9
5
:
0
5
1
9
9
3
:
1
2
-
1
9
9
5
:
0
5
1
9
9
3
:
1
1
-
1
9
9
5
:
0
5
1
9
9
3
:
1
0
-
1
9
9
5
:
0
5
1
9
9
3
:
0
9
-
1
9
9
5
:
0
5
1
9
9
3
:
0
8
-
1
9
9
5
:
0
5
1
9
9
3
:
0
7
-
1
9
9
5
:
0
5
1
9
9
3
:
0
6
-
1
9
9
5
:
0
5
1
9
9
3
:
0
5
-
1
9
9
5
:
0
5
THEILVELO_M1_MOD1 THEILVELO_M1_MOD1A THEILVELO_M1_MOD2 THEILVELO_M1_MOD2A
THEILVELO_M1_MOD3 THEILVELO_M1_MOD3A
2
Graph 11b THEIL COEFFICIENTS FOR M1 MONEY DEMAND VELOCITY
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
1
9
9
5
:
0
5
-
1
9
9
5
:
0
5
1
9
9
5
:
0
4
-
1
9
9
5
:
0
5
1
9
9
5
:
0
3
-
1
9
9
5
:
0
5
1
9
9
5
:
0
2
-
1
9
9
5
:
0
5
1
9
9
5
:
0
1
-
1
9
9
5
:
0
5
1
9
9
4
:
1
2
-
1
9
9
5
:
0
5
1
9
9
4
:
1
1
-
1
9
9
5
:
0
5
1
9
9
4
:
1
0
-
1
9
9
5
:
0
5
1
9
9
4
:
0
9
-
1
9
9
5
:
0
5
1
9
9
4
:
0
8
-
1
9
9
5
:
0
5
1
9
9
4
:
0
7
-
1
9
9
5
:
0
5
1
9
9
4
:
0
6
-
1
9
9
5
:
0
5
1
9
9
4
:
0
5
-
1
9
9
5
:
0
5
1
9
9
4
:
0
4
-
1
9
9
5
:
0
5
1
9
9
4
:
0
3
-
1
9
9
5
:
0
5
1
9
9
4
:
0
2
-
1
9
9
5
:
0
5
1
9
9
4
:
0
1
-
1
9
9
5
:
0
5
1
9
9
3
:
1
2
-
1
9
9
5
:
0
5
1
9
9
3
:
1
1
-
1
9
9
5
:
0
5
1
9
9
3
:
1
0
-
1
9
9
5
:
0
5
1
9
9
3
:
0
9
-
1
9
9
5
:
0
5
1
9
9
3
:
0
8
-
1
9
9
5
:
0
5
1
9
9
3
:
0
7
-
1
9
9
5
:
0
5
1
9
9
3
:
0
6
-
1
9
9
5
:
0
5
1
9
9
3
:
0
5
-
1
9
9
5
:
0
5
THEILVELO_M1_MOD4 THEILVELO_M1_MOD4A THEILVELO_M1_MOD5 THEILVELO_M1_MOD5A
THEILVELO_M1_MOD6 THEILVELO_M1_MOD6A
3
Graph 11c THEIL COEFFICIENTS FOR M1 MONEY DEMAND VELOCITY - Models 4, 4a, 5, 5a
1993:10-1995:05
1994:05-1995:05
0.03
0.05
0.07
0.09
0.11
0.13
0.15
1
9
9
5
:
0
5
-
1
9
9
5
:
0
5
1
9
9
5
:
0
4
-
1
9
9
5
:
0
5
1
9
9
5
:
0
3
-
1
9
9
5
:
0
5
1
9
9
5
:
0
2
-
1
9
9
5
:
0
5
1
9
9
5
:
0
1
-
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THEILVELO_M1_MOD4 THEILVELO_M1_MOD4A THEILVELO_M1_MOD5 THEILVELO_M1_MOD5A THEILVELO_M1_MOD6
4
Graph 12a THEIL COEFFICIENTS FOR M2 MONEY DEMAND VELOCITY
0
0.02
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THEILVELO_M2_MOD1 THEILVELO_M2_MOD1A THEILVELO_M2_MOD2 THEILVELO_M2_MOD2A
THEILVELO_M2_MOD3 THEILVELO_M2_MOD3A
5
Graph 12b THEIL COEFFICIENTS FOR M2 MONEY DEMAND VELOCITY
0
0.05
0.1
0.15
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0.25
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THEILVELO_M2_MOD4 THEILVELO_M2_MOD4A THEILVELO_M2_MOD5 THEILVELO_M2_MOD5A
THEILVELO_M2_MOD6 THEILVELO_M2_MOD6A
0
6
See also http://www.som.hw.ac.uk/cert/wpa/2001/Graph12c.xls
Graph 12c THEIL COEFFICIENTS FOR M2 MONEY DEMAND VELOCITY - Models 4, 4a, 5, 5a
1993:12-1995:05
1994:05-1995:05
0
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THEILVELO_M2_MOD4 THEILVELO_M2_MOD4A THEILVELO_M2_MOD5 THEILVELO_M2_MOD5A THEILVELO_M2_MOD6
7
See also http://www.som.hw.ac.uk/cert/wpa/2001/Graph13.xls
0.119
0.051
0.192
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0.176
0.077
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0.291
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0.3
MOD1 MOD1A MOD2 MOD2A MOD3 MOD3A MOD4 MOD4A MOD5 MOD5A MOD6 MOD6A
Graph 13 Average Theil coefficients for M1 and M2 models for the 0, 1, 2,... 24
steps ahead forecasts
Average Theil coefficient for M1 models Average Theil coefficient for M2 models
1
Of course, the rapid growth of inter-enterprise debt is a prominent development in a
financially repressed economy, but may be also regarded as a normal institutional
development on the road to building the necessary confidence for future trade relations
and tends to regulate itself once sufficient credible information becomes available in the
creditor-debtor partnership. The consistency of reform policies have contributed
significantly to the speed and efficiency of the learning process in the building of trust
within the above-mentioned partnership. This might explain why arrears build-up was
short-lived in countries like Hungary, the Czech Republic and Poland and why it
became a chronic phenomenon in countries like Romania and Russia.
In the period under consideration, the demand for transaction money depended more on
the level of uncertainty in the nominal economy (represented by the price inflation and,
to some extent, by the nominal depreciation rate of the national currency), and less by
other opportunity costs variables or by the dynamic of the real economy. The holdings
of real money in the broad sense seems to be influenced slightly more by the overdue
TC extended and received, suggesting that we should look at arrears more in a portfolio
adjustment approach, than as a substitute for transaction money.
Another notable observation from the Theil coefficient series is that the quality of the
forecasts improves as the forecasting horizon increases
45
. This is due to the fact that our
simple money demand-money supply model is meant to describe a long run equilibrium
situation, and ignores the possible short-term disequilibrium on the money market that
could be captured using monthly data series. [ Therefore, the longer the forecasting
horizon, the better the model describes the dynamics of the monetary variables. Graphs
11c and 12c also reveal that the quality of the forecasts for a horizon longer than one
year becomes slightly better for the models including the real arrears variable (in the
case of models 4and 4a, as well as 5 and 5a). This would suggest that the presence of
TC arrears could have an impact on money velocity in the longer run, as a component
and determinant of portfolio choices made by firms as money-holders, but not
necessarily in the short-term, as an immediate substitute for transaction money.
5. Conclusions and policy implications
This paper has looked at aspects of financial repression in Romania as a TE, reflected
specifically in the behaviour of money velocity. As an aggregate measure of financial
intermediation, money velocity in its narrow measure velocity of M1 and its broad
measure velocity of M2 has a contradictory story to tell. Whether an increase in

45
Note that I use within-sample dynamic forecasts that would be very similar to predicted values if it was not for the
presence of AR and lagged variables terms. Normally, the quality of the forecasts would be expected to decline with
the number of steps ahead used. In our models the value of the Theil coefficient levels off or increases slightly as
well, if we go beyond the 24-months ahead forecasts presented here
2
velocity is a good sign of financial deepening and institutional development in the
financial markets or a bad sign an increase in unpaid debts, barter transactions and
use of foreign currency in the black and grey markets is sometimes difficult to say. It
remains a field of future research that can accommodate a variety of approaches,
theories and methodologies.
Even if the increase in M1 and M2 velocities in the first post-socialist years in Romania
could be partly a sign of increasing monetary transactions, eliminating idle monetary
balances held during years of shortage under central planning, it is unlikely that the
subsequent increase in M1 velocity (but not M2 velocity) reflects an increase in
financial intermediation. Therefore, it is possible that alternative financing sources
(such as IEA, bank and tax arrears) have been used for escaping liquidity and credit
constraints and helped maintain a higher levels of commercial transactions than would
otherwise have been possible under tight monetary policies used to fight inflation. The
key question arising at this point is whether these perverse financial innovations have
thus interfered with the efficiency of monetary policy at the macroeconomic level and
their effect on money velocity is a possible reflection of this fact.
The empirical testing of this point in section 4 was focused on IEA as a controversial
issue in transition literature and policy debate. A high stock of IEA is not in itself a
matter of concern, since it may be due to the structural and institutional determinants of
commercial relations between suppliers and clients in the process of extending trade
credit. However an increase in the flow of real inter-enterprise arrears
46
could be a sign
of a dysfunctional payments system. Under this assumption, firms in transition are NOT
subject to hard budget constraints, but only to credit and liquidity constraints enacted
through restrictive monetary policies only. These, however, act indiscriminately on
ALL firms, or, worse, affect disproportionally new businesses, SMEs, and private firms,
which are the primary source of growth in a healthy developing economy. The lack of
institutional and structural reforms is therefore preventing financial deepening by
conflicting with macroeconomic stabilisation policies.
I have tested the impact of real IEA on M1 and M2 velocities both by simple empirical
regressions (Section 4.1) and by means of a small money market model (Section 4.2).
In the first analysis, I have run single equation regressions of the velocity of M1 (and
M2 respectively), on a few monetary and financial variables: (i) the quasi-money to M1
ratio: (ii) the average real commercial lending rate; (iii) the inflation rate- current and
lagged; (iv) the real non-government credit aggregate; iv) the real public debt and,
finally; (vi) the aggregate value of gross real IEA. The data supports the hypothesis that
all factors related to financial deepening and economic stabilisation (the decreases in the
ratio between quasi-money and transaction balances; the increase in real non-
government credit, real commercial lending rates, and tighter monetary policies) are
conducive to lower money velocity. As expected, M2 velocity is slightly more sensitive

46
Real IEA can not increase indefinitely, but they may rise asymptotically up to a maximum value determined by the
volume of final transactions in the economy, because consumers of final products have to pay their purchases in cash.
For a proof of this statement see Dulgheru (1999)
3
than M1 velocity to changes in real non-government credit and real interest rates and
less sensitive to the change in quasi-money/transaction money ratio.
However, the real IEA aggregate has a very small influence on money velocity in both
denominations (a slightly stronger influence on the M2 velocity), the respective
coefficient being only marginally significant and positive. This suggests that, even if the
presence of a higher volume of real IEA increases money velocity in the economy (as
the theoretical priors would indicate, if we accept IEA as a substitute for transaction
balances), the impact is very low and could be a transitory development in a transition
economy, where institutional patterns of commercial trade credit are still uncertain.
In the second analysis I adopt a simple money demand money supply model similar to
the one used in Zahn and Hosek (1973) and I estimate the system, first without
including the real arrears variable as explanatory variable. Thereafter, I modify the
model by including the aggregate real IEA as a determinant of money demand
(assuming it, again, a substitute for transaction balances). Unlike the Zahn and Hosek
(1973) model that uses a trade credit aggregate as exogenous, I endogenise the variable,
by adding one equation to the system and making real IEA dependent on a scale variable
(real GDP as a proxy for the total volume of transactions in the economy) and previous
period money balances as a proxy for the liquidity availability of the firm. I estimate 6
alternative specifications of the models with and without arrears to find a better fit and
to test the robustness of estimation results. Computing the money demand velocity
forecasts from both models and comparing their performance using the Theil inequality
coefficient, we find that, in all cases, the models that do NOT contain the real IEA
variable perform better or at least as well as the models including the real IEA
aggregate.
Both analyses point out to the same conclusion: the impact of real inter-enterprise
arrears on money velocity and, hence, on the monetary transmission mechanism,
between 1991-1995, in Romania, is non-significant. Therefore, all policies that have
targeted IEA (specifically the multilateral trade debt compensation exercise at the end of
1991-beginning of 1992) have over-stated their importance as a menace to
macroeconomic stability. The efforts in the realm of financial reform could have been
put to a better use by dealing with the institutional set-up that allows non-performing
firms to resort to alternative financing sources (such as bank, tax and trade arrears) in
the first place. This observation is confirmed by the subsequent developments in
Romania: total arrears in the economy have reached 38% of the GDP, IEA have
stabilised at about 16% of the GDP (in December 2000)
47
while more and more firms
are falling into arrears with the fiscal authorities. The tax debt re-scheduling lobby is
one of the most debated issue in 2000-2001, as much as the financial blockage issue

47
Reliable data regarding the aggregate level of arrears has been hard to come by after 1995. This estimate was
published in the newspaper Romnia liber!, December 10, 2000, quoting government adviser Lucian Croitoru. By
comparison, the level of overdue credit as percentage of GDP was 17% in France (1990), 11% in Poland (1993), 15%
in Hungary (1991) from Schaffer and Turley (1999)
4
as the IEA problem is designated in Romanian policy debate used to be contended in
the mid-1990s.
The self-regulating nature of trade credit is taking effect in transition economies in
some slower than in others. Secondary markets in trading commercial debts have been
working in Poland and a private multilateral debt compensation system has been
inaugurated in 2000 in Romania by the Management and Information Technology
Institute, clearing over 15.3 billion lei (approx. 0.75 million &) from the stock of
overdue trade debt until October
48
. Nevertheless, it is trade creditors themselves that
have inevitably acted towards reducing IEA, by NOT extending trade credit to
defaulting customers, once they are forced to adapt the products they supply to the
liquid market demand (see the same reference as in footnote 45)
Although I have not addressed the issue of overdue bank debt in this paper, the
Romanian experience has been relevant for the simple solution to soft budget
constraints fuelled by a largely state-owned and inefficient banking system:
privatisation and hardening budget constraints for state banks. The collapse of two
major state banks in 1999 and the privatisation of other two important state banks have
started the genuine reform of the Romanian banking system by proving the firm
commitment of the government and monetary authorities to let even the largest
Romanian commercial bank go bankrupt.
This self-regulating mechanism is not, however, that straightforward in the case of
arrears with the state budgets, where defaulters can still find incentives to increase their
overdue debts by rent seeking opportunities. Government authorities, as well as large
state-owned utility suppliers are the most likely candidates for perpetuating soft budget
constraints in the case of the Romanian economy, as has happened in Russia in the past
decade (see Pinto, Drebentsov, and Morozov, 2000). Therefore, the recommended
solution to effective financial deepening, that can only be achieved and sustained in a
stable macroeconomic environment is continuing to close all escape valves of soft
budget constraints and rent-seeking opportunities for inefficient firms, without starving
viable firms of liquidity and investment capital, through tight credit and monetary
policies unassisted by structural reforms.
The present analysis is, unfortunately, confined to the period 1991-1995. Therefore, the
first direction of future research should be expanding the time frame of the analysis,
once data becomes available. This would also allow for making the model more
realistic by adding more equations and endogenising some variables (such as inflation
and national income). Also, as shown in Dobrescu (2000), omitting the underground
(unregistered) economy from the analysis, especially in the case of Romania, could
significantly distort the relevance of estimated coefficients in a system like the one used
in the model in Section 4.2. Using an adjusted measure of GDP (to include the

48
Romania Liber! October 11, 2000
5
underground economy) could also shed new light on the use of arrears and their
influence on money velocity.
The literature on arrears has worked on extremely different methodological grounds
when dealing with either IEA, bank arrears, tax or wage arrears. Future research should
also be directed towards creating a common framework for dealing with all these
sources of perpetuating soft budget constraints in a unified manner, as a prerequisite for
designing consistent policies to counteract them.
1
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1
Annex 1 Testing the difference in the series of Theil coefficients for up to 24 months forecast of M1 and M2 velocities
between similar models with and without endogenous arrears
t-Test: Paired Two Sample for
Means
t-Test: Paired Two Sample for
Means
THEILVELO_M1_
MOD1
THEILVELO_M1_
MOD1A
THEILVELO_M2_
MOD1
THEILVELO_M2_
MOD1A
Mean 0.119301326 0.191907177 Mean 0.051292211 0.063127838
Variance 0.001062414 0.001783261 Variance 2.18769E-07 0.001233247
Observations 25 25 Observations 25 25
Pearson Correlation 0.990576159 Pearson Correlation 0.27100799
Hypothesized Mean Difference 0 Hypothesized Mean Difference 0
Df 24 df 24
t Stat -33.31299602 t Stat -1.691105305
P(T<=t) one-tail 6.58974E-22 P(T<=t) one-tail 0.051882038
t Critical one-tail 1.710882316 t Critical one-tail 1.710882316
P(T<=t) two-tail 1.31795E-21 P(T<=t) two-tail 0.103764076
t Critical two-tail 2.063898137 t Critical two-tail 2.063898137
t-Test: Paired Two Sample for
Means
t-Test: Paired Two Sample for
Means
THEILVELO_M1_
MOD2
THEILVELO_M1_
MOD2A
THEILVELO_M2_
MOD2
THEILVELO_M2_
MOD2A
Mean 0.175927731 0.199556792 Mean 0.076770443 0.079338976
Variance 0.001897954 0.001964603 Variance 0.001539852 0.001832012
Observations 25 25 Observations 25 25
Pearson Correlation 0.999781683 Pearson Correlation 0.999738146
Hypothesized Mean Difference 0 Hypothesized Mean Difference 0
Df 24 df 24
t Stat -99.20827629 t Stat -3.487488081
P(T<=t) one-tail 3.46308E-33 P(T<=t) one-tail 0.000950127
t Critical one-tail 1.710882316 t Critical one-tail 1.710882316
P(T<=t) two-tail 6.92616E-33 P(T<=t) two-tail 0.001900254
t Critical two-tail 2.063898137 t Critical two-tail 2.063898137
t-Test: Paired Two Sample for
Means
t-Test: Paired Two Sample for
Means
2
THEILVELO_M1_
MOD3
THEILVELO_M1_
MOD3A
THEILVELO_M2_
MOD3
THEILVELO_M2_
MOD3A
Mean 0.113887524 0.210589951 Mean 0.069535064 0.071451937
Variance 0.002757494 0.003493794 Variance 0.001369344 0.001743964
Observations 52 52 Observations 25 25
Pearson Correlation 0.983184481 Pearson Correlation 0.99941387
Hypothesized Mean Difference 0 Hypothesized Mean Difference 0
Df 51 df 24
t Stat -57.33956257 t Stat -1.939010068
P(T<=t) one-tail 2.75177E-48 P(T<=t) one-tail 0.032172444
t Critical one-tail 1.675284693 t Critical one-tail 1.710882316
P(T<=t) two-tail 5.50353E-48 P(T<=t) two-tail 0.064344887
t Critical two-tail 2.007582225 t Critical two-tail 2.063898137
t-Test: Paired Two Sample for
Means
t-Test: Paired Two Sample for
Means
THEILVELO_M1_
MOD4
THEILVELO_M1_
MOD4A
THEILVELO_M2_
MOD4
THEILVELO_M2_
MOD4A
Mean 0.078326152 0.08223487 Mean 0.074914249 0.077301939
Variance 0.000995303 0.001327315 Variance 0.00143906 0.001726996
Observations 25 25 Observations 25 25
Pearson Correlation 0.999973458 Pearson Correlation 0.999748799
Hypothesized Mean Difference 0 Hypothesized Mean Difference 0
Df 24 df 24
t Stat -3.996516846 t Stat -3.200728801
P(T<=t) one-tail 0.000265783 P(T<=t) one-tail 0.001916958
t Critical one-tail 1.710882316 t Critical one-tail 1.710882316
P(T<=t) two-tail 0.000531566 P(T<=t) two-tail 0.003833916
t Critical two-tail 2.063898137 t Critical two-tail 2.063898137
3
t-Test: Paired Two Sample for
Means
t-Test: Paired Two Sample for
Means
THEILVELO_M1_
MOD5
THEILVELO_M1_
MOD5A
THEILVELO_M2_
MOD5
THEILVELO_M2_
MOD5A
Mean 0.083651199 0.083954232 Mean 0.07059324 0.069818277
Variance 0.001131159 0.001230036 Variance 0.001464495 0.00168671
Observations 25 25 Observations 25 25
Pearson Correlation 0.99998621 Pearson Correlation 0.999635598
Hypothesized Mean Difference 0 Hypothesized Mean Difference 0
Df 24 df 24
T Stat -1.04464355 t Stat 1.292309618
P(T<=t) one-tail 0.153298034 P(T<=t) one-tail 0.104277422
T Critical one-tail 1.710882316 t Critical one-tail 1.710882316
P(T<=t) two-tail 0.306596067 P(T<=t) two-tail 0.208554844
T Critical two-tail 2.063898137 t Critical two-tail 2.063898137
t-Test: Paired Two Sample for
Means
t-Test: Paired Two Sample for
Means
THEILVELO_M1_
MOD6
THEILVELO_M1_
MOD6A
THEILVELO_M2_
MOD6
THEILVELO_M2_
MOD6A
Mean 0.080196675 0.291443869 Mean 0.073108288 0.193769312
Variance 0.001077793 0.001902067 Variance 0.001558919 1.90804E-05
Observations 25 25 Observations 25 25
Pearson Correlation 0.999302498 Pearson Correlation -0.896710426
Hypothesized Mean Difference 0 Hypothesized Mean Difference 0
Df 24 df 24
T Stat -97.12379192 t Stat -13.88724357
P(T<=t) one-tail 5.75796E-33 P(T<=t) one-tail 2.87199E-13
T Critical one-tail 1.710882316 t Critical one-tail 1.710882316
P(T<=t) two-tail 1.15159E-32 P(T<=t) two-tail 5.74399E-13
T Critical two-tail 2.063898137 t Critical two-tail 2.063898137
Notes 1. THEILVELO_M1_MOD1 signifies the average Theil coefficient for the M1 money velocity forecasts (0, 1, 2, up ot 24 steps ahead) provided by model 1 (that
does not include the real arrears vriable). Similarly, THEILVELO_M1_MOD1a refers to the model 1a, which DOES include the arrears variable. The meaning of the other
variables is analogous.
2. The blue shading indicates a significantly better average performance of the first model (without arrears) and the yellow shading indicates there is no significant (at
the 5% confidence level) difference between the performance of the two (with and without arrears) respective models.