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The Bulgarian Currency Board.

JEL: F4, PO

Bulgaria experienced a severe financial crisis in 1996 and early 1997. Several banks were closed, inflation reached hyperinflation levels and output declined sharply. During this period proposals were put forward to establish a currency board. It was hoped that a currency board would restore confidence and help stabilize the economy.

The Bulgarian currency board was established in July 1997. In establishing a currency board Bulgaria was following the lead of two other small transition economies: Estonia, 1992 and Lithuania, 1994. Recently, Bosnia-Herzegovina has also established a currency board.(1)

In many respects the Bulgarian currency board has been a great success. From hyperinflationary levels in February 1997, inflation fell to single-digit levels in 1998 and 1999. A dramatic fall in nominal interest rates made it possible for the Government to reduce large government deficits. The economy has also begun to grow, albeit more slowly than might be hoped during a recovery period.

A currency board establishes a fixed-exchange rate and, like the gold stand, relies on automatic mechanisms to restore macroeconomic equilibrium. The discretion of policymakers is severely circumscribed. In Bulgaria the currency board has also played an important role in creating more discipline throughout the economy. The central bank cannot lend to commercial banks. Commercial banks have greatly reduced their lending to state enterprises. State enterprises have been forced to restructure. In addition the Government cannot borrow from the central bank; fiscal policy has been more disciplined.

What distinguishes currency boards from other fixed-exchange-rate regimes is the credibility of the exchange rate fix. Credibility depends on both economic and political factors. To sustain confidence, the currency board must have sufficient foreign currency reserves to honor the pledge to exchange local currency for reserve currency. Politically, the Government must be prepared to maintain the fixed exchange rate when adverse circumstances arise. To build confidence in the currency board and make it difficult to change the exchange rate, the exchange rate was written into the law establishing the Bulgarian currency board. Whether there is the political will to sustain the board will not really be known, however, until there is a real test. Thus far the Bulgarian currency board has not been confronted with a real challenge, but growing current account imbalances may create problems in the near future.

While the currency board in Bulgaria has been enormously successful in bringing down inflation, it has only been in place since July 1997. In this paper we take a longer-term prospective and assess not only the board's immediate impact, but also its prospects for the future. Two issues are of special concern. The first is Bulgaria's large foreign debt. Bulgaria has been able to service this debt since the crisis ended in 1997, but the debt issue could become more serious if current account deficits persist. The second concern is whether the automatic adjustment mechanisms which maintain balance-of-payments equilibrium under a currency board arrangement will create so much economic pain that they will not be politically sustainable. Without political support the credibility of the currency board will be undermined, and the currency board will not be sustainable.

To analyze these issues we begin by providing a brief description of the performance of the Bulgaria economy since the transition began. In Section II we describe the basic structure of the currency board in Bulgaria. In Section III we utilize a framework provided by Williamson (1995). He presents a list of advantages and disadvantages of currency boards. In this section we analyze whether advantages he identifies with currency boards have indeed brought about the improvements that would be anticipated. In Section IV we examine features of currency board arrangements which Williamson considers to be disadvantages to determine whether they are likely to cause serious future problems for the Bulgarian economy. Section V concludes.

I. Macroeconomic Performance of the Bulgarian Economy

While the period of transition has been difficult for many countries in Eastern Europe, the macroeconomic performance of the Bulgarian economy has been among the weakest. (See Table 1 below.) After a sharp decline in output at the beginning of the transition, the economy began to grow slowly in 1994. In 1996 and 1997 Bulgaria experienced a severe financial crisis and output fell again. In July 1997, after the currency board was established, the economy began to grow again. In 1999 the economy continued to grow in spite of the war in Kosovo, but the economy still has not returned to the output level reached at the end of 1995.(2)
Table 1:
Basic Economic Indicators

 1991 1992 1993 1994 1995 1996

Inflation- 473.9 79.6 63.2 121.9 33.1 310.8
 based on CPI (end
 of period, percent)
GDP Growth -11.7 -7.3 -1.5 1.8 2.1 -10.9
Base Interest 54.00 41.00 52.00 72.00 34.00 180.00
 Rate (end of
 period)
Budget -5.3 -5.4 -11.4 -5.8 -5.7 -10.5
 Balance(**)
Current -1 -4.2 -10.4 -0.3 -0.2 0.9
 Account(**)
Trade balance -32.0 -212.4 -885.4 -16.9 121.0 187.6
(U.S.$)

 1997 1998 1999

Inflation- 578.4 1.0 6.2
 based on CPI (end
 of period, percent)
GDP Growth -6.9 3.5 2.4
Base Interest 6.65 5.08 4.46
 Rate (end of
 period)
Budget -3.1 1.1 -0.9
 Balance(**)
Current 4.2 -2 -5.4
 Account(**)
Trade balance 368.8 -315.6 -1064
(U.S.$)

(**) As a percent of GDP

Source: BNB, National Statistical Institute (NSI)


Until recently inflation has also been a serious problem. Prices were decontrolled in February 1991 and prices rose sharply. Inflation later came down but remained at high levels. In the spring of 1994 the nominal value of the lev fell significantly, and inflation surged again. The onset of the financial crisis in the spring of 1996 caused inflation to rise dramatically, reaching 240% per month in February 1997. With the currency board, inflation has fallen continuously, reaching only 1% per annum in 1998.

Bulgaria is a small country. Total GDP in 1998 was DM 21.6 billion ($12.3 billion). The foreign trade sector is important. In 1998 exports were $4.2 billion or approximately 35% of GDP. Before the transition began, Bulgaria was heavily dependent on trade with the CMEA countries, especially the Soviet Union. Over time, trade with the former Soviet Union has declined and trade with the European Union has increased. In 1999, 52.5% of Bulgaria's exports went to the European Union; less than 10% to the former Soviet Union.

Foreign investment in Bulgaria has been very low. Total foreign investment for the period 1992 -- 1999 is only $2.5 billion or about $315 per person. There were several contributing factors. Bulgaria borrowed large sums in international markets during the 1980s. Unable to meet debt service requirements, Bulgaria declared a moratorium on debt repayments in 1991. The moratorium was lifted in 1994 when negotiations with the London Club were concluded. Other factors that discouraged foreign investors were the high levels of political and economic instability. Since 1991, there have been five governments (and two provisional governments). Along with these political changes there have been many changes in the laws governing business activity.

Since the currency board has been established, the internal economic and political climate has improved, but the international climate has deteriorated. The financial crisis in Russia has reduced international investor interest in the region. The events in Kosovo have reinforced the perception that the Balkans is a high risk unstable region. As a result foreign investment has remained at low levels.

II. The Structure of the Currency Board in Bulgaria

A currency board differs from a central bank in that all its assets are held in liquid reserve-currency assets. The assets of a currency board do not include domestic assets.(3) Because of this limitation a formal currency board cannot hold government debt or act as a `lender of last resort' which lends money to troubled commercial banks.

Two factors that contributed to the Bulgarian financial crisis of 1996-7 were large government deficits and bad loans on commercial bank balance sheets. An attraction of the currency board is that by cutting off credit to both the Government and commercial banks, the currency board disciplines both institutions.

When Bulgaria adopted a currency board in July 1997, it chose the German mark as the reserve currency. This was controversial because the dollar was widely used and oil imports, which are very important, are priced in dollars. The German mark had the advantage, however, that it was soon to be merged with the Euro, and Bulgaria hopes to join the European Union. With the adoption of the Euro in January 1999, the Bulgarian lev is now fixed to the Euro.(4)

The currency board in Bulgaria has a structure similar to the currency board established earlier in Estonia where there is a separation between the Issue department and the Banking Department. In Bulgaria there is also a third division, the Banking Supervision Department. The Banking Supervision Department is the regulator of commercial banks. The Banking Department has reserves that can be used in a crisis situation to help banks. The heart of the currency board is the Issue Department. The balance sheet of the Issue Department for December 30, 1999 is presented in Table 2. All foreign currency assets are entered on the balance sheet of the Issue Department. Since the exchange rate is fixed at 1 lev/DM, the total foreign assets of the currency board were approximately DM 6.3 billion ($3.1 billion).(5)
Table 2:
Monthly Balance Sheet of Issue Department
as of 12/30/1999

ASSETS thousand BGN

Cash and nostro 1,641,530
 accounts in
 foreign currency
Monetary gold 641,788

Foreign 3,913,582
 securities
Accrued interest 75,181
 receivable

ASSETS 6,272,081

LIABILITIES thousand BGN

Currency in circulation 2,082,918

Bank deposits and 639,450
 current accounts
Government deposits 2,693,288
 and accounts
Other depositors' accounts 369

Accrued interest payable 148
Banking Department deposit 855,908

LIABILITIES 6,272,081

Source: BNB


An important difference between this balance sheet and the typical currency board balance sheet is the presence of government deposits and Banking Department deposits on the liability side of the account. Theoretically, the only liability of a currency board would be the monetary base. As Table 2 shows, government deposits and deposits of the Banking Department together are actually greater than the monetary base (M0).

The Banking Department provides a safety valve in the event of crisis. The high inflation and sharp depreciation of the lev that occurred during the financial crisis greatly reduced the value of the money supply. With more foreign currency reserves than were needed to provide coverage for M0, reserves were set aside for the Banking Department. Additional loans from the IMF have also made it possible to increase the size of the Banking Department.

This structure has important advantages for a country that has an ongoing IMF program and large foreign debt service obligations. With a currency board changes in foreign reserves will affect the size of the money supply. With this structure IMF tranches and payments of foreign debt obligations do not affect the monetary base. This arrangement reduces the volatility of the money supply that would otherwise be affected by large movements in the BNB's holding of foreign currency reserves.(6)

This arrangement has some additional consequences, however. First, because of these accounting features, changes in the monetary base will not be equal to the country's overall balance of payments surplus or deficit when the Government is engaged in international transactions. International activities of the Government are "spontaneously sterilized" whether they are IMF tranches, foreign debt payments or receipts from privatization deals with foreign investors.(7)

Second, government deficits will automatically be financed by printing money. An increase in government spending will increase the monetary base and have the same effect on the money supply as a decision by a central bank to buy government bonds when the government deficit spends. For the same reasons, normal government receipts and payments will affect the size of the monetary base and create additional money supply volatility. To reduce this volatility, Nenovsky and Hristov (1998) have argued that government deposits should be held at a commercial bank instead of the currency board.

There are several tradeoffs to be considered here. Government deposits were originally placed at the currency board because the banking system was considered to be too weak. (Enoch and Gulde, 1997) If deposits were placed at a commercial bank, IMF tranches and debt service payments would create more money supply volatility than the present arrangements. Another alternative would be for the Government to keep deposits at both the currency board and commercial banks. The deposits at the currency board could be used for IMF tranches and debt service, and the deposits at commercial banks could be used for normal government operations. A possible disadvantage of this arrangement is that the Government could influence the size of the monetary base by moving deposits from one account to another.

From the viewpoint of a purist, none of these arrangements is ideal.(8) Since the Government's deposits and its international transactions are large, Government activities will influence the size of the monetary base. Under ideal conditions, money supply adjustments under a currency board system should reflect only imbalances in the balance-of-payments.

III. Advantages of a Currency Board

1. Convertibility

A key aspect of a currency board is its guarantee of currency convertibility at a fixed exchange rate. To assure convertibility there must be adequate reserves to cover any demands for foreign currency. For a currency board where commercial banks hold their reserves at the currency board, sufficient reserves to cover M0 will be adequate to guarantee the fixed exchange rate but insufficient to prevent a banking crisis. Commercial banks themselves will not have sufficient foreign currency to guarantee the convertibility. People will be forced to withdraw money from the banks and present their demands for foreign currency at the currency board. The currency board will be able to honor these demands, but the withdraws will bring about a contraction of bank liabilities and the money supply as banks are forced to call in their loans and sell other assets.(9)

In Bulgaria gross foreign currency reserves far exceed the minimum requirements for coverage of M0. As Table 2 illustrates the Issue Department has foreign currency reserves of 6.2 billion lev and M0 is only 2.6 billion lev. At the end of December 1999 foreign currency reserves at the BNB were more than twice as large as M1. Indeed the ratio Broad Money/foreign currency reserves was only 1.17. These figures suggest that the Bulgarian currency board should be able to honor its commitments to the exchange rate fix.

While there should be no immediate problems, the longer-term picture is not so rosy. At the end of November 1999 Bulgaria's foreign debt was more than $9.7 billion. During 1998 debt service was almost $1.1 billion and through November 1999, it was $932 million. Annual service obligations for 2000 - 2001 are in the same range. To put these figures in perspective, the Government's deposits in Table 2 represent approximately one and half year's service payments. The total assets of the Issue Department are approximately the same as the debt service obligations over the next three years.

The future strength of the currency board depends on the management of these foreign debt service obligations.(10) It is interesting to note that while servicing approximately $1 billion per year in foreign debt obligations in 1998 and 1999, government balances at the BNB have actually increased by $500 million and the assets of the currency board have increased by approximately $900 million.

The level of foreign debt in December 1997 and November 1999 was almost the same ($9.7 million), but the composition was very different. Short-term publicly guaranteed debt has been paid off completely, but indebtedness to Official Creditors, mainly the International Financial Institutions (IFIs) [i.e. the IMF, World Bank, European Union, etc.] increased by $440 million.(11) Thus the IFIs have lent important support to the currency board.(12)

Other potential sources of foreign currency reserves include foreign direct and portfolio investment and floating a Eurobond. Attracting private portfolio money or floating a Eurobond has been made more difficult by the financial crises in emerging markets, especially the crisis in Russia. The war in Kosovo has further highlighted problems in the region.(13) Efforts to attract foreign direct investment have focussed on privatization efforts. Foreign direct investment was $636 million in 1997, $537 million in 1998 and $739 million in 1999. Privatization of state-owned enterprises has averaged $220 million in 1998-99.

In these foreign direct investment figures there are also early indications that foreign companies are beginning to investment more in their Bulgarian subsidiaries. If these flows continue, these are important new trends. Bulgaria needs to expand its exports to reverse what is becoming a serious deterioration in its balance of trade. (This is discussed more below.)

The high inflation that preceded the establishment of the currency board in Bulgaria created a situation where there were more than enough foreign reserves to provide immediate cover for M0, but without the support of IFIs, the foreign debt problem could still threaten the viability of the board. Because of these debt problems, dependence on the IFIs has grown over the past two years. It is still too early to determine whether the stability provided by the currency board will provide sufficient impetus to the private sector to reverse this trend, but it is unlikely that these changes will occur quickly.

2. Macroeconomic Discipline

Advocates of currency boards argue that they will tend to instill macroeconomic discipline. Williamson views fiscal policy, in particular, as a political problem that may or may not be solved by the establishment of a currency board.

Very weak commercial bank balance sheets and large government deficits helped bring on the Bulgarian financial crisis in 1996-7. Proponents of the currency board hoped that the establishment of the currency board would signal a change of regime and greater economic discipline.

During the period leading up to the crisis the BNB provided commercial banks with refinancing. The banks then loaned the money to enterprises. These loans were a form of implicit subsidy since there was little chance they would be repaid. "Until 1996, commercial credit was expanded to the nonfinancial sector in Bulgaria to a degree that was unprecedented relative to any other European transition economy." (OECD, 1999, p. 32)

Government attempts to recapitalize the banks failed. The Government replaced bad loans to enterprises with government bonds. Banks then made additional loans, and their balance sheets did not improve. The government bonds increased the level of government debt and the interest obligations on this debt ballooned creating large government deficits. By 1996 interest payments were 17% of GDP.

The currency board has effectively brought an end to these problems. Since the Bulgarian currency board cannot hold domestic debt, it cannot refinance the banks nor can it hold government debt. The high inflation during the crisis reduced the value of the lev-denominated government debt from 70% of GDP in 1996 to less than 15% of GDP at the end of 1998. Interest rates also fell dramatically greatly reducing the servicing burden. (OECD, 1999) The fiscal budget was in surplus in 1998. For 1999 the government deficit was 0.9%, but this reflects expenditures to upgrade a badly deteriorating infrastructure.

The situation in the banking sector has also improved dramatically. The banks have reduced their exposure to the non-financial sector and the capitalization adequacy ratios of the banks rose to more than 40% in 1999 (against the minimum requirement of 10%). Initially the banks did little additional lending to the non-enterprise sector and expanded their cash holdings and their holdings of securities. As Table 3 illustrates, more recently banks have expanded the amount of lending to the non-financial sector and reduced their cash holdings, but the banks are still lending very conservatively.
Table 3:
Aggregate Bank Balance Sheets
(Percentages of major asset categories)

 Dec. Dec. Dec. Dec.
 1996 1997 1998 1999

Cash 10% 19% 14% 11%
Securities 24% 24% 20% 20%
Claims on banks and 24% 29% 32% 33%
other financial institutions
Claims on non-financial 39% 22% 27% 29.5%
institutions

Source: BNB


The currency board was instituted at a time when people had little faith in macroeconomic policymakers and the economy was in a shambles. By bringing more discipline to banking and government budgetary policy, the currency board has enhanced macroeconomic instability. This is certainly a major accomplishment. While the economy has not grown rapidly, it has been stabilized, and it is easier for economic decision makers to make new business plans with longer horizons.

3. Confidence in the Monetary System and the Promotion of Trade, Investment and Growth

Another important aspect of a currency board is that it should create confidence and promote trade and growth. A recent empirical study by Ghosh, Gulde and Wolf (1998) finds that countries that adopt currency boards do have better inflation experiences, and this improved inflationary environment does promote better growth.

When the currency board was adopted in July 1997, there were immediate indicators of confidence in the exchange rate fix. As illustrated in Figure 1, interest rates fell dramatically as the establishment of the currency board was anticipated. Interest rate reached single-digit annualized levels once the board was in place.(14)

[ILLUSTRATION OMITTED]

These changes are to be expected since speculators will arbitrage between the German mark and Bulgarian lev. The interest rate premium on lev securities is a measure of the additional risk in the Bulgarian market. The interest rate differential between the German mark three month LIBOR and the three month Bulgarian government bond has been around 2% since the beginning of 1998.

This dramatic fall in nominal interest rates had two important effects. First, lower interest rates greatly reduced the Government's domestic debt service obligations and helped the Government gain control of its budget. Secondly, the fall in nominal interest rates occurred before inflation came down. At first real interest rates were negative, although they have recovered as inflation has also come down.

While the currency board has been able to stabilize the exchange rate, it has not brought dramatically increased inflows of foreign capital. A number of privatization deals have been completed, but the deterioration in the capital stock over the past decade has been so great that many firms have very little value. Foreign direct investment climbed, but the crisis in emerging markets and the war in Kosovo have hurt. Per capita foreign investment remains much lower than in most other Eastern European countries.

IV. Disadvantages of a Currency Board

In this section we discuss four disadvantages of a currency board identified by Williamson: (a) the transition problem which arises when inflation leads to overvaluation of the real exchange rate; (b) the adjustment problem caused by BOP disequilibrium (c) the crisis problem in the banking system because there is no lender of last resort; and (d) the political problem.(15)

1. Transition Problem

The transition problem is the problem of bringing inflation down quickly enough after the establishment of the currency board. Fixing the exchange rate should bring inflation down, but inflation can have a momentum that leads to an overvaluation of the real exchange rate. The gold standard mechanism will eventually correct the BOP imbalance that results, but the adjustment can be long and painful.

In Bulgaria there was some inflationary momentum, but it was short lived. Following the very high inflation during the first half of the year, the CPI rose only 16% during the second half of 1997 and only 1% in the 1998. In 1999 the inflation rate was 6.2%. This is low but is still higher than the inflation rate in Germany. (See Figure 4.)

[ILLUSTRATION OMITTED]

To determine whether this inflation would cause an overvaluation of the lev depends on where the nominal exchange rate fix was initially set. Figure 2 plots the real exchange rate (lev/$) deflated by the PPI for the period beginning in February 1991. As can be seen in the graph, the real exchange rate fluctuated dramatically during the period immediately preceding the establishment of the currency board. This made it more difficult to determine an appropriate nominal rate. While perhaps a little undervalued, the nominal exchange rate chosen secured a real rate in the middle of the range during the 1990s. Since the currency board system was implemented, the lev has appreciated about 7% against the dollar in real terms. Because inflation in Germany has been very moderate during this period, the real appreciation relative to the German mark has been 25%.

[ILLUSTRATION OMITTED]

There is considerable disagreement about the importance of this real appreciation. Banerji and Gelos (2000) have looked carefully at this question. To some extent the measured appreciation may be overstated because of the Balassa- Samuelson effect. They concluded that the real appreciation during the currency board period has been "quite moderate compared with other transition economies" (p. 12) They point out that this situation could change, however, if productivity improvements do not continue.(16) An important factor here is that wages in Bulgaria measured in U.S. dollars are among the lowest in the region.

On the other hand, Dobrinsky (2000) is more concerned about the competitiveness of Bulgarian exports and worries that lack of competitiveness could lead to further deterioration in the balance-of-payments.

At present the most serious problem is that the balance on current account has moved from surplus to deficit. See Table 4. So a transition problem has arisen. The current account surplus in 1997 was $426 million and the current account deficit in 1998 was $272 million. Preliminary figures for 1999 show the current account deficit increasing to $663 million. The deterioration in the trade deficit is even more severe, moving from a $380 million surplus in 1997 to a deficit of more than $1 billion in 1999. Some of the deterioration in 1999 can be attributed to the war in Kosovo and the difficulties associated with trade routes to Western Europe through Yugoslavia which have been blocked since the war.(17)
Table 4:
Foreign Trade Balances 1997 - 1999

(in millions of USD) 1997 1998 1999

Current Account 426.7 -272.7 -663.3
Trade balance 380.4 -329.5 -1068.2
Exports, fob 4939.7 4294.0 3859.8
Imports, fob 4559.3 4623.5 5027.0

Change from 1997:

Current Account -699.4 -1090
Trade balance -709.9 -1448.6
Exports, fob -645.7 -1079.8
Imports, fob 64.1 467.7

Source: BNB


Most of this shift is occurring in the trade balance. As Table 4 illustrates, most of change in the trade balance between 1997 and 1999 is due to a fall in exports, although a significant rise in imports 1999 also contributed to the shift. The decline in exports reflects a realignment towards the EU. Exports to the former Soviet Union fell by more than half between 1997 and 1999 (-$525 million). Exports to Turkey also fell by more than a third (-$158 million). By comparison exports to the EU remained virtually the same. (-2.6%).

Rising imports in 1999 reflected increases in both investment and consumption goods. Preliminary GDP statistics for the first three quarters of 1999 also indicate that investment is expanding. Investment through September 1999 is just below the level for all of 1998.

While it is not yet severe, Bulgaria has a current account deficit problem. Bulgaria has been hurt by the crisis in emerging markets, particularly the crisis in Russia and its affects on other countries in the region. However, the real problem is that Bulgaria has been unable to expand its export trade in any other major region.

2. Adjustment Problems

Unlike other countries that have had a currency board for a longer period of time, the currency board in Bulgaria has not really been tested. This may soon change with the growing current account deficits. While there was no speculation against the lev when the Russian crisis occurred, continuing current account deficits could cause a contraction in the economy. (18)

Under a currency board arrangement there are two automatic adjustment mechanisms if current account deficits arise. 1) If the current account deficits create BOP deficits, the monetary base will contract; the money supply will fall, and aggregate demand will decline. Either a fall in output or a decline in prices will improve the current account balance. The greater the decline in prices, the smaller the decline in output needed to bring about equilibrium. 2) If the current account deficits are offset by capital account flows, expanded investment in the economy will lead to greater export potential. Greater exports will reduce future current account deficits.

Figure 3 plots the movement of the monetary base over the period of the currency board. (The peaks occur in December of each year.) The dramatic increase in the monetary base in late 1997 when the currency board was first established reflects a portfolio readjustment following the hyperinflationary period that preceded it. Holding leva was a much safer bet than before. This created an inflow of foreign currency reserves. In 1998 and 1999, MO continued to increase, although at a less dramatic rate.

[ILLUSTRATION OMITTED]

From these figures it is clear that the current account deficits are not creating a monetary contraction. On the other hand, the decline in exports is reducing aggregate demand. This should slow the growth of the economy. If the money supply contracted, this would reduce aggregate demand even more.

Under a currency board arrangement there is little that can be done to offset these contractionary pressures. In a more flexible policy environment expansionary fiscal or monetary might slow the contraction. If Bulgaria had a floating exchange rate, a depreciation of the real exchange rate might spur exports. None of these options exist under a currency board.

The impact of contractionary policies on prices can be very important. If prices are more flexible in a downward direction, the contraction in output should be less severe. Figure 4 shows the relationship between monthly CPI adjustments in Germany and Bulgaria. The increase in the CPI during the first six months of the currency board was higher in Bulgaria, but in 1998 the CPI increases were almost the same; 0.6% in Germany and 1.0% in Bulgaria. The volatility of price adjustments in Bulgaria was much greater. In several months Bulgarian prices fell, in part because food prices fell almost 5% in 1998. This suggests that Bulgarian prices might indeed fall more during a contraction than a country like Germany. This should ease the output effects of a contraction caused by the adjustment process that will take place under a currency board arrangement.

Since there has not been a contraction in the money supply, improvements in the current account depend on the second mechanism where increases in foreign investment improve productivity. Higher investment levels, more imports of investment goods and signs, finally, of enterprise restructuring are indications that improvements in productivity may be possible. Still it is too early to determine whether these productivity improvements will be sufficient to bring about near term improvements in the current account.

3. Crisis Problem

What Williamson refers to as the crisis problem arises because there is no "lender of last resort" under a formal currency board. In Bulgaria there is more flexibility. When the currency board was established, a Banking Department was created to provide protection during a crisis. A substantial amount of money was put aside in the Banking Department and has increased since the board was created. In June 1999 the deposits of the Banking Department at the Issue Department were 140% of bank reserves. (Table 1).

Offsetting this advantage is the small presence of foreign banks in Bulgaria. Most countries with currency boards have been countries where foreign banks were dominant, as with the British colonies. Hong Kong and Argentina are exceptions, but the presence of foreign banks in these countries is also greater than in Bulgaria. Argentina experienced a run on its banks in 1994-5 during the Mexican debt crisis. (19) The exchange rate was maintained, but reserve requirements were reduced by half-- a very non-currency board thing to do. The IMF provided large loans, and small banks were absorbed by large banks. (Williamson, 1995) Since then Argentina has organized large lines of credit which can be called upon in the event of another crisis.

If banks have lines of credit in foreign currency upon which to draw, the contraction will be less severe. Foreign banks should be able to draw on their parent banking institutions for resources in the reserve currency, especially if their parent is in the reserve currency country. For Bulgaria today any bank from Euroland would serve this function. With the sale of Bulbank, formerly the Foreign Trade Bank, to foreign interests, a substantial part of banking assets is in banks with foreign ownership.(20)

It is difficult to judge what will happen during a financial crisis, but one can interpret from portfolio behavior what economic agents perceive the risks to be. Under a currency board the risk of currency devaluation is reduced, but the risk of bank failure is greater. In Figure 5 the cash-to-deposit ratio is plotted for the period beginning in December 1990.(21) As can be seen from the figure, the cash-to-deposit ratio rose dramatically when the currency board was established. This rise reflects the greater confidence in the lev as people exchanged dollars for lev. But confidence in the banks is still weak.

[ILLUSTRATION OMITTED]

The behavior of banks has also been conservative since the establishment of the currency board. Figure 6 shows the ratio of bank deposits to reserves. During the currency board period the required reserve ratio (also shown on the graph) was 11%. Until very recently banks have been holding reserves well above this level. As seen in Table 3, recently banks have become more aggressive and have reduced their cash holdings and extended more loans. In part this reflects changes in the procedures for determining compliance with the minimum reserve requirements, but it may also reflect pressures on bank profitability. It is difficult for banks to make profits if they are holding large cash balances and low interest paying government securities.

[ILLUSTRATION OMITTED]

4. Political Problem

The last disadvantage that Williamson lists is the political problem. The question he raises is whether the currency board will really impose controls on the fiscal authority. He remains skeptical that this will necessarily be the case.

Thus far the currency board in Bulgaria has created an environment where the Government has been able to control budget deficits. If there is a political problem, it is the appearance, perhaps, that the currency board is too strong. In political debate the Government has used the currency board to deflect demands on the budget. This has created an environment where the greatest political threat to the currency board is not the fiscal actions of the present Government, but the political attacks on the currency board.

Ganev and Wyzan (2000) argue that these attacks are coming from elites that have, in the past, been able to extract money through their control of enterprises. This extraction is more difficult now that the currency board is hardening these budget constraints. Previously this group has had the support of the poor who feared that restructuring would result in job loss. As restructuring is proceeding, unemployment is rising. Ganev and Wyzan state that it remains to be seen whether this rich-poor coalition will form again and politically threaten the currency board.

V. Conclusions

The currency board has brought needed discipline to the Bulgarian economy. The money supply is no longer growing too rapidly. Government budgets are now under control. Banks lending is much more cautious. The result is that inflation has come down dramatically, and the economy is beginning to grow.

Having met these challenges, there are others that still lie ahead. Bulgaria still has a very large foreign debt. The servicing of the debt is still a problem, and there is a heavy reliance on the IFIs to provide support for these payments. These problems have been made more difficult because the current account is now in deficit.

The current account deficit may well create the most serious challenge for the currency board. This deficit has arisen in large measure because the economy has not been able to respond to changing conditions outside Bulgaria. Furthermore, declining exports are contractionary, and the currency board arrangement provides no mechanism for offsetting these forces. At the same time, Bulgaria is being spared an even more painful experience since the contraction is smaller than it would have been if the money supply had not continued to expand. Even if the money supply does not fall, a decline in output at this stage could create additional political problems.

The longer-term solution to these problems, however, is growth. It is still too early to determine whether the increased stability brought on by the currency board and the inflow of new foreign capital will be sufficient to increase productivity. If productivity improves, Bulgarian goods will become more competitive and the current account will readjust. If productivity does not improve, then the long-term viability of the board will be in question.

The biggest problem that must now be faced is probably a political problem. If the current account deficits continue to increase and the economy contracts, there will be additional pressure on the Government to take action. The currency board limits the options that the Government has. If political uncertainty reduces confidence that currency board arrangement will survive, the currency board could lose credibility, increasing the risk of speculation against the lev. It is, therefore, crucial that strong political support for the currency board be maintained.

(*) The paper benefited from discussions with Nikolay Nenovsky, Kalin Hristov, Boris, Petrov, Lubomir Christov, Andrew Kenningham, Kenneth Koford and anonymous referees. Any errors in the paper are the author's responsibility. This is an updated version of a paper first prepared for presentation at the conference on Banking Reform in South East European Transitional Economies, Sofia, 23-26 June, 1999.

Notes

(1.) See Bennett (1992) for a discussion of the Estonian currency board.

Proposals have also been put forward to establish a currency board in Russia (See Hanke, Jonung and Shuler (1993)). Hanke also proposed a currency board for Bulgaria in 1991. Recently, he visited Montenegro where he has made a recommendation that a currency board be instituted there also.

Since the Asian Crisis and the success of the Argentinean currency board, there has been extensive debate about the viability of currency boards. For some earlier discussion of currency boards see Liviatan (1993), Schwartz (1993) Williamson (1995). Shuler maintains a web site with references to papers about currency boards. It can be found at www.dollarization.org

Some earlier discussions of the Bulgarian currency board include Hanke (1997), Minnasian (1998), Yotsov, et. al. (1998), Nenovshy and Hristov (1998), Avramov (1999), and Dobrev (1999).

(2.) For a more detailed description of the performance of the Bulgarian economy during this period see OECD (1999)

(3.) In Argentina the reserve currency is the U. S. dollar and the currency board does hold some dollar denominated government debt.

(4.) Lithuania's currency board has used the US dollar as its reserve currency. As the issue of accession into the European Union becomes more important, Lithuania is considering switching to the Euro. Estonia's currency board used the German mark as its reserve currency.

(5.) On July 5, 1999 the new lev was created at the rate of 1 new lev = 1000 old leva. This made the exchange rate 1 lev = 1 DM.

(6.) IMF tranches actually pass through the Banking Department and borrowings from the IMF are a liability of the Banking Department. There is a four -week window after the tranche is received where the Government can make a decision to borrow this money from the BNB. The government can then make payments from this account to service the foreign debt. (A special exception was written into the law establishing the currency board allowing the Government to borrow these funds from the BNB.) (Enoch and Gulde, 1997)

Careful consideration is also given to how money from the World Bank affects the money supply. Money that is passed to the Government and eventually spent by the Government will affect the money supply, but the World Bank is careful that the original transfer of funds to the Government does not significantly affect the monetary base. See Gulde (1999) for an analysis of issues surrounding the establishment of the currency board.

(7.) Sterilization is usually associated with situations where central banks try to stop monetary contractions when balance of payments deficits arise. The situation here is different since there is no discretionary policy action being taken.

(8.) This is one of the reasons why Hanke refers to the Bulgarian system as a "currency board like system" rather than an orthodox currency board.

(9.) Caprio, et. al. (1996) analyze how these questions are tied to the lender-of-last resort function. If commercial bank liabilities are not guaranteed, then they will trade at a discount. Then the lender-of-last resort function is closely tied to the promise of convertibility at a fixed exchange rate.

(10.) An alternative, perhaps, would be default. This would be an unwise policy. The moratorium on payments on its foreign debt before the London club settlement in 1994 had a damaging effect on foreign investment.

(11.) This increase of $440 actually represents the net change since Bulgaria made principal payments of $670 million on earlier loans from these same organizations.

The short-term debt was owed to CMEA countries. Bulgaria was able to buy this debt on the money market at a considerable discount and retire it. Most of the increase in indebtedness to Official Creditors occurred in 1998.

(12.) Presently, Bulgaria is dependent on long-term IMF loans. If the IMF changes the direction of its program, as some critics have suggested, and stops its long-term loan programs, this could have serious repercussions for Bulgaria unless other IFIs expand their lending.

(13.) While the war in Kosovo has made it more difficult to attract private capital flows, it has strengthened Bulgaria's position in its negotiations to obtain additional funds from the IFIs.

(14.) Figure 1 shows movements in the base rate of interest. This interest rate is based on the yield at primary auctions of three-month government securities. It reflects the supply of bonds issued by the Government and is therefore not an entirely free floating rate. The long-mn movement of interest rate in Figure 1 is, however, reflective of overall interest rate movements in the economy.

(15.) The other issues that Williamson discusses are: seigniorage, the start-up problem and the management problem. Currency boards allow countries to collect seigniorage where simply using another reserve country's currency does not. The start-up problem is the problem of collecting sufficient foreign currency reserves before establishing the currency board. The management problem is the inability of a country with a currency board to manage its monetary policy. This last problem is discussed below when the adjustment problem is analyzed.

(16.) On the other hand, greater competition may put more pressure on Bulgarian firms to restructure and become more competitive. (I would like to thank a referee for pointing this out.)

(17.) An important difference between Dobrinsky (2000) and Banerji and Gelos (2000) is that Dobrinsky argues that this deterioration is a reflection of deteriorating competitiveness and Banerji and Gelos attribute the balance of trade problems to the Russian and Kosovo crises.

(18.) There are some indications that the economy may be slowing. Unemployment has risen from 15% to 18% in early 2000. (However, unemployment statistics in Bulgaria have not been very reliable.)

(19.) It was during this period that the existing foreign banks in Argentina greatly expanded their activities and became a significant presence in Argentina. See Clark, et. al. (1999)

(20.) The State Savings Bank is now the largest bank without foreign ownership interest. It was not a commercial bank but is presently being prepared for sale to foreign investors.

(21.) Deposits include both lev and foreign currency deposits.

References

Avramov, Roumen. 1999. "The Role of a Currency Board in Financial Crises: The Case of Bulgaria" Bulgarian National Bank Discussion Paper DP/6/.

Banerji, Angana and R. Gaston Gelos. 2000. "Does Bulgaria Suffer from a Competitiveness Problem? A Look at Real Exchange Rate Indicators and Export Performance" in "Bulgaria: Selected Issues and Statistical Appendix" IMF Staff Country Report No. 00/54, April.

Caprio, Gerard, Jr; Michael Dooley, Danny Leipziger and Carl Walsh. 1996. "The Lender of Last Resort Function Under a Currency Board: The Case of Argentina, World Bank Policy Research Working Paper 1648, September.

Clark, George, Robert Cull, Laura D"Amato, and Andrea Molinari. 1999. "The Effect of Foreign Entry on Argentina's Domestic Banking Sector," World Bank Policy Research Paper Working Paper 2158, August.

Dobrev, Dobrislav. 1999. "The Currency Board in Bulgaria: Design, Peculiarities and Management of Foreign Exchange Cover, Bulgarian National Bank Discussion Paper DP/9/.

Dobrinsky, Rumen. 2000. "Fiscal Policy Under a Currency Board Arrangement: Bulgaria's Post-crisis Policy Dilemmas" Vienna Institute for International Economic Studies (WIIW) Research Report No. 256, March.

Enoch, Charles and Anne-Marie Gulde. 1997. "Making a Currency Board Operational," IMF Paper on Policy Analysis and Assessment, Monetary and Exchange Affairs Department, International Monetary Fund.

Ganev, Georgy and Michael Wyzan. 2000. "Bulgaria: Macroeconomic and Politicaleconomic Implications of Stabilization under a Currency Board Arrangement," Center for Liberal Studies, Sofia.

Gulde, Anne-Marie. 1999. "The Role of the Currency Board in Bulgarian Stabilization," Finance and Development, September, pp. 36-39.

Ghosh, Atish, Anne-Marie Gulde, and Holger C. Wolf. 1998. "Currency Boards: The Ultimate Fix?," Policy Development and Review Department, Monetary and Exchange Affairs Department, International Money Fund, WP/98/8, January.

Hanke, Steve H., Lars Jonung, and Kurt Shuler. 1993. Russian Currency and Finance, Routledge, London.

Hanke, Steve H. 1997. "Good News from a Bad News Spot," Forbes Vol. 159, No. 4: 106. February 24.

Liviatan, Nissan (ed.) 1993. "Proceedings of a Conference on Currency Substitution and Currency Boards," World Bank Discussion Papers, 207.

Minassian, Garabed. 1998. "The Road to Economic Disaster in Bulgaria" Europe-Asia Studies, Vol. 50, No. 2:331-350.

Nenovsky, Nikolay and Kalin Hristov. 1998. "Financial Repression and Credit Rationing under Currency Board Arrangement for Bulgaria," Bulgarian National Bank Discussion Paper, DP/2/98.

Organization for Economic Cooperation and Development. 1999. Economic Survey of Bulgaria, 1999, OECD, Paris.

Schwartz, Anna. 1993. "Currency Boards: Their Past, Present and Possible Future Role," Carnegie-Rochester Conference Series on Public Policy, 39:147 -87.

Williamson, John. 1995. What Role Currency Boards?, Institute for International Economics, Washington, D.C.

Yotzov, Victor, Nilolay Nenovsky, Kalin Hrsitov, Ira Petrova and Boris Petrov. 1998. "The First Year of the Currency Board in Bulgaria," Bulgarian National Bank Discussion Paper, DP/1/.

Jeffrey B. Miller Department of Economics University of Delaware
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