Research Center Working Paper Series No.

17

The Currency Board Arrangement: the case of Bulgaria and the Boards Relevance to the Countrys Membership in the European Union by Desislava Eneva Undergraduate Major in Economics Saint Anselm College Manchester, N.H 03102-1310 Class of 2010

Eneva 2 Introduction The currency board is an arrangement that provides an alternative to the establishment of a central bank as the entity in control of monetary policy. Since the primary function of a central bank is controlling the supply of money, the potential for abuse of discretion by policymakers can create economic disturbances. Furthermore, countries that are characterized by weak political and monetary institutions, such as emerging market and transition countries, often lack the tools necessary for economic stabilization when such disturbances occur. The development prospects of a country, however, are heavily dependent on the stability of its macroeconomic framework, which in turn is inextricably linked to the political and economic relations to other countries. A sustainable exchange-rate mechanism is therefore essential to macroeconomic stability. In the midst of economic instability, a viable stabilization policy might thus involve the control of exchange rates, and in particular the commitment to an exchange-rate target. The latter, however, is not always the best solution due to the fact that a lack of transparency and commitment to the regime might exacerbate a countrys economic instability and result in an even greater financial crisis. It is in that context that the currency board arises as the path to achieving macroeconomic stability that has been chosen by a multitude of developing countries, such as Bulgaria, Hong Kong, Djibouti, Lithuania, Estonia and Brunei (Labonte and Makinen). I. The Currency Board Arrangement (CBA) The currency board is a monetary regime characterized by the establishment of a fixed exchange rate and the reliance on automatic mechanisms to restore macroeconomic equilibrium, which implies that the discretion of policy-makers is significantly curtailed (Miller 54). The boards primary function is to issue and exchange, on demand, the local currency at a

Eneva 3 fixed rate for the anchor currency, also known as the reserve currency, whereby the currency issued is secured 100% by the reserve currency. The regime is usually adopted to demonstrate a countrys commitment to anti-inflationary policy and involves a long-term commitment to the system (Gulde). To ensure the viability and success of the CBA, it is important to link the domestic currency to the currency of an anchor country that exhibits similar economic fluctuations in order to avoid the potential adverse impact of severe external shocks, which, because of the rigidity of the restrictions on domestic discretionary policy associated with the CBA, cannot be dealt with internally. In addition, the credibility of the system is heavily dependent on political support, since sustaining the exchange-rate fix, even in adverse economic circumstances, necessitates the full commitment of the government to the CBA. It is important to note the distinction between the currency board and dollarization. Both regimes convey a strong commitment to the fixed exchange-rate target, the only difference being that the currency board allows the country to preserve the advantage of seigniorage. Furthermore, the board is seen as being more flexible but involving a somewhat weaker commitment to the target, since the arrangement can be abandoned and the value of the countrys currency can thus be unlinked from the anchor currency (Mishkin 557). II. Advantages The CBA has both political and economic advantages that make it an attractive monetary system. First of all, the mechanism is effective in eliminating high inflation, which can be seen as the result of a better monetary discipline (Ialnazov and Nenovsky 38). Moreover, the CBA imposes a significant restraint on fiscal policy, since the government is prevented from financing budget deficits by printing money, because the latter is rendered

Eneva 4 impossible by the fact that local currency can only be issued in exchange for reserve assets and the reserve currency. Securing acceptable ranges of inflation is crucial for the smooth operation of market economies, and therefore the CBA, through the stable currency and monetary system it promotes, appears to be a good monetary system which explains its adoption by certain countries. Apart from reducing inflation and ensuring that the government has a strong incentive to maintain a balanced budget, the CBA exhibits a further advantage, namely the alleviation of the time-inconsistency problem. Due to their curtailed discretion regarding changes in the money supply, the authorities are incapable of engineering monetary surprises that can be inconsistent with previous announcements. Hence, the currency board avoids the erosion of credibility that is often associated with the central-bank arrangement of monetary policy (Labonte and Makinen 10). Additional benefits of the CBA include the tendency of domestic interest rates to converge to the rates prevailing in the reserve currency country, therefore further promoting economic stability. The CBA is also efficient in reducing exchange-rate risk, thus curbing uncertainty and trade transaction costs, which ensures a more stable economic environment and promotes international trade and investment. Since the latter two factors are crucial for the sustainable economic growth of developing countries, the CBA, with its relatively more trustworthy exchange-rate commitment than other fixed-rate mechanisms, can be seen as having a strongly beneficial impact on the economies of developing countries (Labonte and Makinen 11). In summary, the CBA, because of its transparent rules of policy-making, can have a desirable credibility effect that creates confidence in the system and thus facilitates economic growth, trade and investment.

Eneva 5 III. Disadvantages Although it has a variety of beneficial effects, the CBA also possesses a number of negative characteristics. First of all, since independent monetary policy is rendered impossible, the central bank cannot use the adjustment of the exchange rate and interest rates to facilitate the absorption of external shocks to the economy. The only options in that case are wage and price adjustment, which however, might take effect more slowly and be more painful (Ialnazov and Nenovsky 41). Furthermore, while restraining the discretion of policy-makers, the regime is also a detriment to the development of intelligent and responsible fiscal and monetary policy. Poirot, for instance, argues that although the CBA might improve oversight and monitoring and thus encourage desirable behavior in the financial system and the government, it limits liquidity creation to the flow of international reserves, which might be an excessive cost to the economy, considering the fact that there might be other, less costly alternatives to ensuring central bank oversight (Poirot 35). Another negative aspect of the CBA is the fact that it cannot serve as a lender of last resort (LOLR). Although all domestic currency is backed by foreign reserves, this is not the case with bank deposits. Therefore, if the amount of excess foreign exchange reserves does not meet banks liquidity needs in the event of a systemic crisis, not all deposits would be honored by the currency board. What is more, the board is prohibited from holding any domestic assets, which means that it cannot hold government debt or act as LOLR (Miller 56). A solution could be ensuring the presence of a multitude of foreign banks that could use lines of credit from parent banking institutions during a liquidity crisis. Another option is securing credit from foreign commercial banks, central banks, or the International Monetary Fund (IMF) (Ialnazov and Nenovsky 40).

Eneva 6 Further disadvantages include the restricted ability to use expansionary fiscal policy, the lack of possibility to devalue the local currency in order to stimulate exports, and the reduced competitiveness of exporters in the face of the possibility of real appreciation of the national currency resulting from a strengthening of the anchor currency (Ialnazov and Nenovsky 42). In summary of the discussion about the positive and negative aspects of the CBA, it must be noted that the advantages and disadvantages are most probably varying depending on the country in which the regime is implemented. It appears that the benefits outweigh the costs, but that might not indicate that the CBA is necessarily a better alternative to a central bank arrangement with a fixed exchange-rate commitment, especially in countries with responsible governing bodies and transparent policies. On the contrary, it seems that the CBA is suitable for smaller countries characterized by underdeveloped financial and regulatory systems, incomplete fiscal and monetary policy record, profligate fiscal pasts, bouts of high inflation, or ongoing currency crises. The following consideration of the CBA in Bulgaria aims to illustrate the above points by examining the specific features of the Bulgarian board. It will also attempt to show that the regime has indeed benefited the country and that it can be seen as facilitating the full accession of Bulgaria to the European Union. IV. Bulgaria: Introduction and distinctive features of the CBA The primary reason for the adoption of the CBA in Bulgaria on 1st July, 1997 was the severe twin exchange-rate and banking crisis of 1996-1997 that eventually led to hyperinflation in the beginning of 1997 (Stefanov 139). The roots of the crisis are to be found in Bulgarias lack of experience in running a market economy: Bulgaria had recently emerged from the communist regime, which left the country not only with an unfavorable industrial structure, but

Eneva 7 also a large foreign debt (Ialnazov and Nenovsky 32). Bulgaria started the transition with an independent central bank, that, however, was under significant political pressure leading it to extend loans to the government and to refinance the banking system, which in turn promoted soft lending by banks to loss-making state-owned enterprises. State-owned banks suffered imminent losses thus necessitating government bailouts that resulted in huge deficits, high inflation and loss of public confidence in the banking system (Ialnazov and Nenovsky 33). By January 1997 inflation had soared to 500% and by March it had surpassed 2000%, the cause being the liquidity injections to the banking system, the extensive financing of the budget deficit by the central bank, and the diminished confidence in the local currency, the Bulgarian lev (Gulde 1). The expectations of the depreciation of the lev were provoked by the large debt servicing obligations of the country that were due in 1996. The lack of confidence in the currency and the banking system led to panics in which the population rushed to banks to exchange lev deposits for hard currency and to withdraw foreign-denominated deposits, while the central bank, Bulgarian National Bank (BNB), because of diminishing currency reserves, was unable to intervene in the foreign exchange market and support the lev (Stefanov 54). The only option was to raise interest rates, but that worsened the domestic fiscal situation as it increased the interest on government debt (Poirot 49). The limited intervention of BNB in turn provoked a further loss of confidence, depreciation of the lev, and rising inflation. Furthermore, the declining tax revenues and swelling interest payments on the government debt required growing central bank support, thereby directly deteriorating the situation and further igniting inflation (Minassian 342-343).

Eneva 8 The precarious economic situation had also led to a deteriorating political environment in which the socialist cabinet was reluctant to institute the needed reforms, which led to its resignation in December, 1996 and the appointment of a provisional government in February, 1997. The need for an institutional reform had been evident for a while and in November, 1996 the IMF proposed the CBA as a solution to the macroeconomic instability, but the political situation would hamper the road to recovery. Despite an initial opposition to the proposal, an agreement was finally signed between the IMF and the newly appointed democratic government (April 1997) and the board was launched on 1st July. Initially the deutsche mark was chosen as reserve currency, but it was supplanted by the euro in 1999 with the fix 1 lev=1.95583 euro. The board was established under the Bank of England model, which was considered to exhibit the greatest degree of transparency. The BNB, Bulgarias central bank, was thus reorganized into three departments: the Issue Department, which is the heart of the system and holds all foreign currency assets and is responsible for the issuing and redemption of monetary liabilities for the reserve currency on demand, the Banking Department, which would provide emergency funds in the event of a crisis, and the Banking Supervision Department, which is the regulatory agency of the commercial banking system (Miller 56). In addition, because of the presence of foreign reserves in excess of the monetary base and additional loans from the IMF, reserves were directed to the Banking Department and increased its size, thus providing a safety net for the banking system, a feature of the Bulgarian currency board that allows the BNB, albeit to a very limited scope, to act as a LOLR (Miller 67).What is also distinctive about the Bulgarian arrangement is the presence of government and Banking Department deposits on the liabilities side of the Issue departments balance sheet; typically the only liability of a

Eneva 9 currency board is the monetary base. The rationale for depositing government funds at the Issue Department lies in the undermined confidence in the banking system and the notion that this organization of the CBA would promote less money supply volatility than if government deposits are left with commercial banks (Miller 58). This unorthodox characteristic of the Bulgarian board is represented by the fact that foreign reserves cover not only the monetary base, but also the governments and the Banking Departments deposits at the Issue Department of the central bank. The latter arrangement allows the government to sterilize the inflow of foreign capital, which prevents the fiscal reserve growth from being translated into monetary base growth as would be the case with a traditional CBA (Raiffeisen Research Group). Since its inception, the CBA has been an integral part of a broader scheme of reforms aiming at achieving macroeconomic stability, such as the privatization and reorganization of both the banking and production sectors, the stabilization of the price level, and the goal of attracting foreign investment. In that respect, the board has accommodated greater transparency and security, both of which can be seen as factors promoting economic growth. The immediate impact of the CBA was positive, as can be seen in the first three years of its operation: it led to a sharp decline in the aggregate price level, stabilization of government finances, an increase in foreign exchange reserves, and growth in real GDP that was driven by rising investment and exports. In addition, the CBA introduction promoted reforms in the real sector, namely the liberalization of prices, the acceleration of privatization and the liquidation of loss-making stated-owned enterprises. It also spurred improvement in the banking sector that has subsequently achieved greater solvency and liquidity also facilitated by strengthened regulation and supervision (Ialnazov and Nenovsky 36). Most notably, however, the CBA has assisted Bulgaria in escaping from a cycle of inflation and depreciating currency and has thus returned

Eneva 10 confidence in the national currency, banking system, and government. In more recent years, the stability created by the CBA has been sustained and the Bulgarian economy has been performing well, judging by the substantial increase in the fiscal reserve (fiscal surpluses since 1998), declining external public debt, which exceeded 70% of GDP in 1999 and is currently around 10%, stability in the banking sector, and political stability (Raiffeisen Research Group). VI. The CBA and Bulgarias accession to the Euro Zone Bulgaria has been an official member of the European Union since 1st January, 2007, but still has not fully acceded to the European Monetary Union (EMU). The EMU, an integral part of the EU, is based on single monetary policy and coordinated economic policy of the member countries and aims at the same economic objectives as the EU, namely stable economic growth and low inflation (Roussenova 1). It is important to note that the path to full membership in the EU includes the following stages: 1) the pre-accession phase, during which the country extends efforts to meet the Copenhagen criteria for joining the EU; 2) Phase 1, in which the country strives to maintain macroeconomic stability in order to meet the convergence criteria; 3) Phase 2, or entry in the European Exchange Rate Mechanism (ERM II), which is a form of stability test before Euro adoption; 4) Membership in the Euro Area (Zone) dependent on satisfying the criteria for price approximation and fiscal criteria, the so-called Maastricht criteria, that determine the degree of convergence of prospective member states to the Euro Zone countries standards. With its accession to the EU in 2007, Bulgaria has made a commitment to become a member of the Euro Area and adopt the Euro, the precondition to which is participation in the ERM II for a minimum of two years. The rationale behind the ERM II is to test the exchange rate stability of the countrys currency. Positive results lead to accession to the Euro Zone, while failure leads to a correction, either devaluation or

Eneva 11 revaluation, which ensures that the countrys entry in the Euro Area is at the appropriate exchange rate (Ialnazov and Nenovsky 43). The standard procedure of EMU participation requires that before entering the ERM, countries restore their central banks and the instruments of monetary policy, which in the case of Bulgaria would mean abandoning the CBA. The European Union institutions, however, have discussed alternative approaches that would enable countries to enter the ERM while preserving their currency boards or by resorting to unilateral euroization, in which discussions it has been suggested that the CBA is compatible with ERM II (Roussenova 7). In addition, some scholars have argued that the CBA has facilitated convergence to the Maastricht criteria (Nenovksy 44) and that it is well-suited to serve a country all the way to its adoption of the Euro (Gulde, Khknen and Keller). Bulgarias position on that point is to preserve the board up to Euro-adoption, which is a manifestation of its sustained commitment to the arrangement (Konstantinova). Currently Bulgaria is still waiting to be accepted in the ERM II, and despite the fact that there are no formal criteria that need to be met, the common opinion expressed in the media is that the high level of inflation, the large current account deficit and the continuing wide-spread corruption are the main obstacles the country has to overcome. Nevertheless, Bulgaria is going to seek entry in ERM II later this year, as inflation and the current account deficit are expected to decline due to the economic slow-down that will lead to subsiding foreign investment and consumption. As can be seen in their April report, analysts from UniCredit Bank anticipate Bulgarias current account deficit to shrink to 9.8% and inflation to fall to 3.5% in 2009. With a stable exchange rate due to the currency peg, a budget surplus throughout the last six years and a debt-to-GDP of 16% well below the 60% requirement, Bulgaria has fulfilled the rest of the Maastricht criteria (BNB Statistics Directorate April 1,2009 Report).

Eneva 12 An alternative to maintaining the CBA and joining the ERM would be euroization, or the adoption of the Euro as a legal tender prior to EMU membership. The current economic downturn has ignited sentiment against the CBA and has provoked a desire to accelerate adoption of the Euro in order to completely eliminate currency risk and to support investor confidence (Bivol, Sofia Echo). Unilateral euroization, however, would lead to a loss of seigniorage and would involve excessive costs of acquiring the Euro notes and coins that would be provided for free under a bilateral agreement. Even worse, adopting the Euro without consent would imply high political costs, since the endeavor would be seen as an attempt to enter the Euro Zone through the back door, and would thus arouse negative sentiment towards Bulgaria that would compromise its integration in the EU (Ialnazov and Nenovsky 45). Both the Finance Minister and the governor of the central bank in Bulgaria have expressed support of the CBA and have noted that euroization is not an option (Bivol, Sofia Echo). VII. Conclusion The CBA has assisted Bulgaria in achieving macroeconomic stability and has instilled needed fiscal and monetary discipline. Having created a predictable economic environment, the arrangement has promoted economic growth and has facilitated Bulgarias accession to the European Union. It must be noted, however, that the lack of policymaker flexibility associated with the CBA might prove to be a significant impediment to Bulgarias quick recovery in the context of the current economic crisis. Heavily dependent on exports, the Bulgarian economy is under severe pressure as devaluation to restore the competitiveness of exports is not an option. There is a danger, therefore, that the costs of maintaining the current regime might be greater than they have previously been. Accelerated accession to the EMU and adoption of the Euro is now a necessity. As an article in the Economist from 26th February, 2009 indicates, a meltdown

Eneva 13 of any of the weaker members of the EU in Eastern Europe, Bulgaria for instance, could have a tremendously negative impact on the union. The effect would be disastrous as a collapse in the east would destabilize the euro and the single market and deteriorate the political climate by undermining the achievement of unification after the end of the Soviet Empire. It is therefore incumbent upon the European Central Bank and the European Commission to facilitate a quicker transition to the Euro by recent members who are at risk, even if that means consenting to the euroization option, something the institutions have so far been reluctant and unwilling to do. In Bulgarias case, accelerated accession to the ERM II, and ultimately to the Euro Zone, would be the best path to stability. The countrys strained relationship with the EU authorities because of Bulgarias continuing problems with corruption, however, makes it unwise for Bulgaria to press the issue by initiating further negotiations and requesting special treatment. In that context, the continued commitment to the currency board, even in the present crisis, seems to be a reasonable political strategy.

Eneva 14 Works Cited Bivol, Alex. "Bulgaria risks angering the European Central Bank." 12 December 2008. The Euro Information Website. 2 March 2009 <http://www.ibiblio.org/theeuro/InformationWebsite.htm>. Gulde, Anne-Marie. "The Role of the Currency Board in Bulgaria's Stabilization." Finance and Development A Quarterly Magazine of the IMF 1 September 1999. Ialnazov, Dimiter and Nikolay Nenovsky. "The Currency Board and Bulgaria's Accession to the European Monetary Union." The Kyoto University Economic Review (2002). Ilieva, Tsvetelina. "Bulgaria seeks quick ERM-2 entry." 1 March 2009. Reuters. 2 March 2009 <http://www.reuters.com/article/bondsNews/idUSL165980820090301>. Konstantinova, Elizabeth. "Bulgaria to Seek ERM Entry This Year, Iskrov Says." 5 March 2009. Bloomberg. 6 March 2009 <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a5c6OUdVbQg4 >. Labonte, Marc and Gail Makinen. A Currency Board as an Alternative to a Central Bank. Congressional Research Service, 26 May 2004. Miller, Jeffrey B. "The Bulgarian Currency Board." Comparative Economic Studies (2001): 53-74. Minassian, Garbed. "The Road to Economic Disaster in Bulgaria." Europe-Asia Studies (1998): 331-349. Poirot, Clifford S. "Did the Currency Board Resolve Bulgaria's Financial Crisis of 199697." Journal of Post Keynesian Economics (2003): 27-55. Raiffeisen Research Group, (2008, January 29). Retrieved March 2, 2009, from Hedgeweek: www.hedgeweek.com/download/241877/Bulgaria%20%20Currency%20Board%20Special.pdf Roussenova, Lena. "Policy Documentation Center." January 2001. Central European Initiative. 1 March 2009 <http://pdc.ceu.hu/archive/00002114>. Stefanov, Stefan. "Implications of the Currency Board in Bulgaria." South-East Europe Review for Labour and Social Affairs (1999): 139-155.