Cause and Effect in European Politics and Law

A paragraph 22 for Bulgaria's euro area membership

Adelina Marini, August 14, 2009

The Greek Eurobank dedicated its July edition of its economic forecasts and analyses to Bulgaria and the comparison to the Baltic states - a topic, regularly discussed in recent months, especially after Latvia was on the brink of a bankruptcy and several international institutions had to help it. In fact, the comparisons between Bulgaria and the Baltic states are being made for a long time because of some similarities:

- Almost all Baltic states + Bulgaria are in a currency board as only Latvia is a partial exception to the rule;

- Again almost all Baltic states + Bulgaria's currencies are pegged to the euro.

A very serious difference is that the three Baltic states - Latvia, Lithuania and Estonia tried to enter the ERM II whose main function is to stabilize the national currencies so as to make the adoption of the euro as painless and cheap as possible. But because of the immense economic growth in the Baltic states (often called Baltic economic tigers), the three states, particularly Latvia, generated high inflation, often double digit. This led to warnings last year of the danger for economic overheating of their economies. And again, the most serious threats were related to Latvia. It was the fast economic growth that led to parallels to Bulgaria and other new EU member states.

What does the analysis of Eurobank show? A possible devaluation of the lat exchange rate vs. the euro is likely to raise the risk of competitive devaluations of other FX pegs in the CEE region,
including the currency boards of Estonia, Lithuania and, to a lesser extent, the currency board of Bulgaria. But the problem is, as Gikas Hardouvelis and Platon Monokrousos write in their analysis is that a lat devaluation would tend to depress financial asset markets in Central Eastern Europe, generating conditions of panic for all nearby emerging economies.

The report also shows that Bulgaria’s currency board is sustainable and would be abandoned only if policy makers believe that this is the best way to proceed for eventual euro area entry. Despite the global financial crisis, heightened regional uncertainty and lingering devaluation worries in the Baltic States, Bulgaria’s currency board continues to be supported by a number of factors, which differentiate it from other FX pegs in Central Eastern Europe:

- First, Bulgaria’s currency board enjoys strong public and constitutional support;

- Second, Bulgaria’s currency board is also supported by both a large pool of foreign exchange reserves and a strong fiscal position, while the current economic recession is much milder than in the Baltic States;

- Finally, Bulgaria’s banking sector is well-capitalized and its central bank has the flexibility to
undertake ‘‘strictly limited’’ lender-of-last resort (LLR) operations.

But what can happen if Bulgaria after all decided to break up the currency board before the euro area membership? The possibility of a break up of the present currency board arrangement and de facto devaluation of the lev ahead of euro adoption can not be totally ruled out. This is especially true, in view of the overvaluation of Bulgaria’s exchange rate and the country’s apparent commitment to enter the euro area as soon as conditions allow. But on the other hand, the experts of Eurobank write that it might not be prudent for Bulgaria to enter the euro area with such an overvalued exchange rate, as overvaluation hurts competitiveness and is extremely difficult to reverse once the country becomes a euro area member.

A decade of experience with the existence of the euro area reveals that overvaluations in individual euro area countries, especially in the European South, tend to persist and result in large current account deficits. Until recently, domestic authorities used to view the problem of Bulgaria’s current account deficit with a certain degree of comfort, thanks to the relatively low share of consumer goods imports (ie., no higher than 15% of total imports). The relevant argument was that the strong growth of investment-related imports would help expand the production capacity and export orientation of the economy, with positive consequences for medium-term growth. That
optimism was also supported by the considerable progress made in recent years towards reducing the
country’s regulatory burden.

A devaluation of the lev ahead of Bulgaria’s euro area entry is possible but at the moment does not carry a very high probability. That is because the costs of devaluation would likely overwhelm any potential benefits. A lev devaluation would deal a severe blow to the balance sheets of domestic businesses and households, given their high levels of external indebtedness. It would thus exacerbate the current financial stress and lead to an even bigger and longer recession. Moreover, later on, if economic growth were to resume, the lev devaluation could likely put upward pressure on
domestic inflation, further delaying the fulfillment of the Maastricht inflation criterion and, consequently, the country’s efforts to join the euro area.

That is why, domestic policy makers are likely to try to keep the status quo, namely maintain the currency board, while taking the necessary policy measures to contain the domestic economic downturn and improve competitiveness. Such a policy path would require reinforced fiscal prudence by the new government and, possibly, some form of financial assistance from the IMF and/or other international organizations, the experts of Eurobank suggest.