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Bulgaria: IMF Urges Adoption Of Currency Board

Washington, 11 November 1996 (RFE/RL) - The International Monetary Fund (IMF) has urged Sofia to adopt a currency board form of central bank because it says "bold action is needed to break the vicious circle" that Bulgaria's economic and financial situation has become.

The fund, in a six-page statement prepared for public distribution in Bulgaria, says the country is "facing an extremely serious economic situation" because of the large budget deficit, a loss of confidence in the banking system and the currency, the depreciation of exchange rates, the continued high rate of inflation, and falling living standards.

One particularly difficult aspect of this situation, says the fund, is that because of the loss in confidence, high interest rates are needed to maintain the value of the currency, but that those high rates then put a "very great burden on the budget, which threatens to undermine financial stability."

It is to break this "vicious circle" that the IMF says it believes a currency board "could be a key element in a solution to Bulgaria's economic problems."

A currency board is a central bank which must operate under specific rules. In the case of Bulgaria, the lev would have to be tied to (have a fixed exchange rate with) a major reserve currency, such as the U.S. dollar or the German Deutsche mark, and the central bank would be required to exchange on demand lev currency for foreign exchange at the fixed exchange rate.

In addition, a currency board central bank would be required to make sure that all the lev currency and the deposits of banks with the central bank are "fully backed at all times" by foreign exchange. The IMF says this means that new lev could only be created in exchange for additional foreign exchange and that the currency board could not extend credit to the government or the banking system.

It has been the easy extension of credit to the government and the banking system by the central bank that has been "the cause of inflation and devaluation in so many countries, including Bulgaria," says the fund.

With the adoption of a currency board system in Bulgaria, says the IMF, "inflation will decline quickly, arresting the decline in living standards and the purchasing power of pensions, wages, and other incomes." And because the exchange rate would be fixed, "savings in lev by the population will maintain their value in foreign currency terms."

Inflation "would be quickly brought down to perhaps about one percent per month," says the IMF, and a currency board would "exchange confidence in financial stability by symbolizing a break with the past -- a past in which credit was all too easily available and often misused."

However, says the fund, while a currency board can bring "substantial benefits, these come at a price." Because a currency board would have a number of restrictions on monetary and fiscal policy, the central bank could no longer lend to the government to make up for any budget deficit. Thus, it says "the budget deficit must be limited at all times to an amount that can be safely financed from domestic bond issues and foreign financing."

Another limitation imposed by a currency board, says the IMF, is that the central bank would have to stop intervening in money markets and would have to give up control over interest rates. Indeed, it says, "interest rates need to adjust under to ensure that capital flows to the currency board match the demand for lev."

The IMF says there would also be "some limitation" on the provision of financial support to banks in the country. However, it adds, there can be a restricted role for the central bank under a currency board to act as a lender of last resort to the banking system. It could do this by using any foreign reserves it has in excess of the amount required for currency support, to lend to the banking system at times when withdrawals might threaten the banking system as a whole.

Because of Bulgaria's recent history of banking problems, the IMF says, it would be important for a currency board in Sofia to start out with "sufficient excess backing to allow for such emergency lending."

Currency boards are officially in effect in four countries in the world, most recently adopted in Estonia and Lithuania. The IMF says that when currency boards were adopted in each of these nations, "interest rates declined rapidly toward the rates in the anchor currency" and that in each one, currency boards have "survived significant banking system problems."

The IMF cautions, however, that a currency board can work only when there is "broad public support for its introduction as well as the firm commitment of the government." Not only must the parliament pass the necessary legislation, but the government generally must fully support the concept.

There is no loss of sovereignty for Bulgaria, says the IMF, because it is an arrangement established by the parliament and run by Bulgarian citizens. The only tie to another country is the fixed exchange rate.

The fund says, "There is little doubt in our view that a currency board has the potential to reduce inflation and interest rates rapidly in Bulgaria, and that in the current circumstances the benefits would greatly outweigh the costs.

"To be successful, however," says the IMF, "a currency board must be reinforced by an adequately restrictive budget that does not require domestic financing on any significant scale. Equally important, the credibility and ultimate success of this strategy also requires that it have broad-based political and public support."

IMF Managing Director Michel Camdessus, in a private letter to Bulgarian presidential advisor Kiril Velev last week, encouraged the government to actively consider the idea of the currency board because Bulgaria's situation is so serious. Camdessus' letter was in response to an appeal by President Zhelyu Zhelev for the IMF to release the second installment of about $116.7 million of a stand-by credit of around $582 million approved earlier this year.

IMF officials say they have not tied adoption of a currency board to release of the rest of the stand-by loan, but only proposed it as a good solution to a bad problem. They emphasize that the problem must be solved, one way or another, before Bulgaria can expect to draw any more of the IMF loan.