From Lev to Euro: Yet Another Challenge

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From Lev to Euro: Yet Another Challenge After 1 January 2007 Bulgaria will face a new challenge – that of joining the Eurozone. The process should be a relatively easy one, yet certain complications exist, which may significantly defer membership in the Eurozone. Adopting the euro will be a more challenging, hard but interesting task than expected. Georgi Angelov

The Currency Board Arrangement and the euro Nine years ago Bulgaria introduced a monetary council (the Currency Board Arrangement, or CBA) as a means to overcome inadequate monetary policy and hyperinflation. The Currency Board has several major characteristics founded on strict rules, which the Bulgarian National Bank (BNB) is bound to observe: • BNB is obliged to buy and sell unlimited amounts of foreign currency (euro) in exchange for the local currency, in cash or via bank transfer. • BNB maintains a currency reserve which corresponds to the total value of money in use. • BNB is not allowed to provide loans to the government. • BNB does not implement a monetary policy – it does not carry out operations at the open market, does not define target interest rates, provide refinancing to banks, or sell currency by sole initiative (currency may be bought and sold only when requested by individuals, companies or banks). • The currency reserve is invested in low risk and liquid assets denominated in the reserve currency. Following the introduction of the CBA as well as other important reforms, the Bulgarian economy has undergone an overall transformation. Inflation has gone down to less than 10%, the Gross Domestic Product has experienced growth alongside investment, while the government has announced budget surplus and the national debt is cut down significantly.

The economy prior to and following the introduction of the currency board

19911997

19982005

210.1

7.2

Inflation Tax Rate (%)

57.7

6.7

Real GDP Growth (%)

-4.7

4.5

Investment Growth (%)

-8.8

18.5

Budget Deficit (% of the GDP)

-6.3

0.6

Government Debt (% of the GDP)

168

61.8

Inflation (%)

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From Lev to Euro: Yet Another Challenge Foreign Direct Investment (mln USD per year) Foreign Direct Investment (% of the GDP)

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1469.2 7.9

Source: Dimitar Chobanov, 9 Years Currency Board Arrangement, Institute for Market Economy, July 2006

It appears irrational that a country would like to change it currency regime if the latter is really considered that successful. There is an old saying which reads, “Never mend something which has not been broken.” The present case, however, is an exception. Through the CBA Bulgaria enters into a monetary union with the Eurozone. The only difference is that in the Eurozone the euro is the currency used in transactions, while in Bulgaria the euro remains in the currency reserve of BNB, with transactions carried out with the lev. The lev, on the other hand, is fully covered by the euro and is fixed to the euro. In reality, when Bulgaria joins the Eurozone and introduces the euro, this will lead to strengthening the current monetary regime and not to it being cancelled or significantly modified. Once in the Eurozone, we will be using the euro to make payments, and not the lev, which is fixed to and covered by the euro. Taken from the same perspective, there will not be a change in that sense. It becomes even more unlikely that a Bulgarian government will repeat the 1996 crisis.

Procedure and criteria for adopting the euro Despite the fact that Bulgaria is in a monetary union with the Eurozone, there is a special procedure that it needs to undergo in order to adopt the euro as its official currency:

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to become a member of the European Union;

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to join the so-called Exchange Rate Mechanism II (ERM II) for no less than two years;

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to fulfill Maastricht criteria while on ERM II;

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to join the Eurozone.

Bulgaria will enter the EU on 1 January 2007. Joining the Exchange Rate Mechanism will follow soon after, since Bulgaria aims to adopt the euro within short terms and there is no real reason to postpone that. Consequently, it is very likely that during the first quarter of 2007 our country will become a member of ERM II. While our country is in ERM II, it will have to fulfill the Maastricht criteria in order to be allowed to join the Eurozone. The criteria are the following:

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From Lev to Euro: Yet Another Challenge

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The budget deficit should be no lower than 3% of the gross domestic product;

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The government debt should be lower than 60% of the gross domestic product;

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Inflation should not exceed by more than 1.5 percentage points the average level in the best performing states;

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The nominal long-term interest rate must not be more than 2 percetage points higher than the average level in the best performing states;

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The exchange rate of the national currency should not vary by more than +/- 15%.

Even at this point Bulgaria fulfils four out of all five criteria. The government not only has no budget deficit, but it has estimated a significant budget surplus. Government debt is two times lower than levels required by the Maastricht criteria, and continues diminishing. The currency exchange rate is fixed by a currency board arrangement. The only problem is that of inflation.

Growth Issues Despite the fact that four out of those five criteria have been met and it seems relatively easy to fulfill the single one remaining, the objective will not be reached that easily. What are the reasons for this? Although the Maastricht criteria were designed as late as the beginning of the 1990s, the European Union at the time was twice smaller than it is now and Member States shared a greater similarity in income, price levels, and the speed of economic growth. In addition, the monetary systems of Member States were not as diverse as nowadays – currency boards, for example, were not familiar in the EU until the 2004 accession of the Baltic States. A European Union of 27 is completely different from what it used to be like at the beginning of the 90s. There are now huge discrepancies in income and price levels in different Member States, which results in higher economic growth in many of them and in inflation in the new Member States. Most of the lower income Member States have to catch up with the rest, which results in greater economic growth and fast increase in income and prices. This leads to rises in the exchange rate for that currency (in the case of floating exchange rates) or to fast increase of inflation (where there is a fixed currency rate, which is the case with Bulgaria). The situation gets further complicated by the EU requirement, aimed at new Member States, to "harmonize" (i.e. increase) excises, which constitute a strong pro-inflation factor, as all smokers and drivers know. In a situation like that, the only way new Member States may meet the inflation (or exchange rate) criterion will be:

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to undergo economic stagnation;

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to use "creative" accountancy and alter the data in order to manipulate statistics (like Greece and Italy);

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From Lev to Euro: Yet Another Challenge l

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to ignore the rules (like Germany and France).

To illustrate how inappropriate the inflation criterion is, we will point out that Ireland, which is the fastest growing and most successful European economy in the last decade, would also have been unable to meet the inflation criterion if this had taken place in 2000 or 2001 when it achieved significant economic growth. It becomes obvious that the most sensible decision is to remove Maastricht critreria or at least to modify them so that they account for changes. The measure, however, has not taken place: the criteria have remained as formulated at the beginning of the 90s in the context of a completely different Union. This has impeded two Baltic States to join the Eurozone together with the first new Member State welcomed in the Eurozone – Slovenia – and it is very likely to cause problems and delay also for the rest of the newly acceding states, including Bulgaria.

Inflation in Bulgaria Current inflation levels in Bulgaria fail to meet the Maastricht criterion. The reasons include a rise in prices due to relatively high economic growth, together with increase in excises, due to European Union requirements, and in administrative prices, and finally a rise in petrol and fuel prices, which has occurred in the last few years. It is expected that in the next few years the same factors will continue to have impact but to a different extent. Although an important part of the rise in excises has already taken place, some of them will continue to grow, if to more limited impact on inflation levels. In this case, the exception is with cigarettes whose price, as initially planned, will have to undergo an abrupt increase in 2010. Judging on developments in the last couple of years, it is likely that administratively defined prices will also face increase, although it is difficult to estimate when this will take place. On the other hand, if due to EU accession the liberalization of certain sectors advances, it is possible that this rise is not high or that it will be avoided. Some predict that the economy will continue to grow fast and inevitably result in a rise in salaries, which will, in effect, cause the cost of services to go up. Additionally, Bulgarian accession to the European Union will most likely bring new players to the bank market and will increase the number of loans. These factors will also influence inflation towards higher levels. To limit the risk of high inflation in the two years during which Bulgaria will be part of ERM II, in 2006 the Bulgarian government has taken out a large share of the excise increase on cigarettes. As a result, inflation in 2006 will be higher, but it is expected that in the following years it will decrease. One crucial problem is that Bulgarian statistics does not produce the so-called harmonized

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consumer price index: this is the index which serves to compare Bulgarian inflation to the Maastricht criterion. The lack of this index so far is an obstacle as far as, when there is no particular data, all speculation on inflation and the criterion is arbitrary. Despite the above problems and additional complications, it is possible that inflation in Bulgaria arrives within the frame of the inflation criterion especially if inflation in all other EU countries experiences a slight increase. By all means, however, Bulgaria will be on the edge and it might happen to experience the unpleasant situation in which Lithuania found itself where due to rounding inflation figures inflation appeared to be 0.1% higher than the level allowed in the criterion. As a result, the country was not allowed into the Eurozone. Yet even if Bulgaria fails to fulfill the requirement set by the inflation criterion and falls slightly short of it, the risk remains that joining the Eurozone will have to be postponed if it decided that price levels are not “sustainable”. This was a valid argument used in the case of Lithuania due to expectations that Gazprom increases the gaz price for the country. Unilateral Euroisation? Brussels disapproves of this approach. In spite of that, Bulgaria may adopt the euro as its currency unilaterally without following existing procedures and criteria, especially likely in the prospect of deferred membership in the Eurozone. When euroisation is a unilateral initiative, the process is much less complex – the government and the BNB will announce that the lev ceases to be used as a means of payment and that everyone can exchange their money for euro. People who store their money in bank accounts do not have to undertake any action because the bank will exchange their savings instead of them. A similar procedure has previously taken place in Bulgaria in 1998 when old levs were exchanged with new once wich had three zeros less. Despite opposition at the European institutions, if there is political will and initiative Bulgaria, as an EU Member State, may unilaterally adopt the euro as its national currency. Once this has become a fact, the Commission and the European Central Bank will have no choice but to accept it (it is hardly possible that even the most somber bureaucrat in Brussels will venture to force the country give up the euro and follow all procedures before eventually adopting the currency). Unilateral euroisation provides a way to avoid the delay and make use of the positive effects immediately. On the other hand, the unilateral euroisation scenario – even if not realized – may be used to strengthen the arguments of the Bulgarian side when negotiating its membership in the

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From Lev to Euro: Yet Another Challenge

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Eurozone. Apparently, adopting the euro will be a more challenging, hard but interesting task than expected.

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