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Bulgaria: Currency Board Starts Strong

By Michael Wyzan

Prague, 15 July 1997 (RFE/RL) - Bulgaria on July 1 became the third Eastern European country in transition - after Estonia and Lithuania - to adopt a currency-board.

Henceforth, the lev will trade at 1,000 to the D-mark and be fully backed by the Bulgarian National Bank's (BNB) foreign reserves. Those reserves consist of foreign currency, precious metals, and securities denominated in foreign currency.

Under a currency board, the exchange rate of the domestic currency against a specified world currency (ordinarily the D-mark or U.S. dollar) is fixed. Further, the only increases in the domestic money supply that are allowed are ones resulting from converting foreign currency inflows into domestic currency. In principle, the monetary authorities can no longer finance government budget deficits.

Bulgaria has, thus, as the Financial Times of London recently put it, "joined the select group of countries to throw away the keys to monetary policy."

In the fall of 1996, as Bulgaria's economy plunged into the deepest economic crisis faced by any European member of the former Soviet bloc, the International Monetary Fund (IMF) made any new lending conditional on Bulgaria's adopting a currency board. Gross domestic product (GDP) had declined by almost 11 percent in 1996, after rising modestly in the two previous years. Consumer prices rose by 243 percent in February 1997 alone, after increasing by only 33 percent in all of 1995. The lev fell from 79 per dollar in April 1996 to almost 3,000 in mid-February 1997, and the monthly wage plunged from the equivalent of $126 in April 1996 to about $35 in February 1997.

The deterioration in macroeconomic performance that began in the spring of 1996 was set off by a decline in the BNB's foreign reserves. That left the central bank without the means to defend the lev against speculative attack. Such attacks were inevitable in an economy in which the currency unit's nominal value remained unchanged for a long period between such attacks, in the face of inflation much higher than in the country's main trading partners.

Behind this instability lay unreformed enterprises and banks, interacting perversely to generate bad debt. When budgetary subsidies to enterprises fell to low levels, firms kept going by borrowing from banks. Firms often had no intention of repaying the loans, and most of the larger banks apparently did not object. The banks were expecting refinancing - that is, lending from the BNB, increasingly without collateral - and government programs to convert bad debt into government bonds.

In December 1995, fewer than 26 percent of commercial bank loans were likely to be amortized in a timely manner, and cumulative state enterprises losses were 14 percent of GDP in 1993, on top of aggregate banking losses of 2-3 percent of GDP.

The currency board is aimed at addressing these fundamental structural problems. Neither direct subsidies from the budget - which may now run only a small deficit - nor BNB refinancing of commercial banks will be possible.

Does adopting a currency board imply a loss of sovereignty? States have adopted all manner of monetary regimes, including using a common currency, as have the twelve CFA countries in West Africa, or using another country's money.

Is Bulgaria's a true currency board? Purists believe that the versions employed by transition countries are not true boards. The national bank continues to exist and operates windows through which citizens can exchange foreign currency; it can still influence the money supply via reserve requirements. Purists would be especially disturbed by the existence of a BNB banking department that could act as a lender of last resort.

For now, macroeconomic indicators are favorable, with inflation of only 8 percent in June and the BNB's foreign reserves at record levels. The credibility of government policy is high, with people rushing to turn D-marks into leva in the board's first days. Interest rates on the government security market have fallen to under 7 percent, a level not reached in Estonia or Lithuania until two or three years after the introductions of their currency boards, and banks are awash in liquidity. Currency market players now seem excessively optimistic, after having the opposite tendency for so long.

In the medium term, problems are bound to emerge. The Baltic experience suggests that inflation will remain rather high (20-30 percent) for several years.

At some point, the policy straight jacket of a currency board may become too painful and the desire to adjust the exchange rate irresistible. This issue is best left to some future date when the economy stands on a sounder footing.