CURRENCY BOARD IN BULGARIA AND STRATEGY TOWARDS EMU

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CURRENCY BOARD IN BULGARIA AND STRATEGY TOWARDS
EMU

• KALIN HRISTOV
• BULGARIAN NATIONAL BANK

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EU AND EURO AREA MEMBERSHIP

• For new member states there is no opt-out clause
  for adoption of the single currency
• The questions are when and how
• Strategy for development of the Bulgarian
  National Bank 2004-2009
• Agreement between the Council of Ministers and
  the Bulgarian National Bank for the adoption of
  euro in Bulgaria

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STRATEGY TOWARDS EURO AREA MEMBERSHIP

• Bulgaria will apply for joining ERM II
  immediately after the date of EU membership
• We intend to enter ERM II at current exchange
  rate 1.95583 BGN for 1 Euro
• Bulgarian authorities unilaterally commit to keep
  currency board until Euro area membership
• Council of Ministers commits to follow balanced
  budget policy and to honour SGP principles

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IS THIS STRATEGY FEASIBLE?

• Experience from the founding and almost founding
  members of the Euro area corner cases - Austria
  versus Greece
• Experience from the new member states - Fast
  track versus On a slow boat to Euro area

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MONETARY INTEGRATION - THAN

• Austrian versus Greece (Hochreiter and Tavlas,
  2004)
• November 1981 Austria fixed its exchange rate to
  deutsche mark at 7.03 ATS per DEM. In 1995
  Austria entered EU and ERM. In 1999 became a
  member of Euro area.
• January 1981 Greece became a member of the EU. In
  March 1998 Greece entered ERM and in 2001 became
  a member of Euro area.

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MONETARY INTEGRATION THANERM II ISSUES

• The timing of entry
• The choice of the central rate
• The width of the exchange rate band
• The length of stay in the mechanism

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MONETARY INTEGRATION - NOW

• What do the new member states bring to EU? How
  different they are and what are implications for
  monetary integration.
• New member states strategies towards ERM II and
  the adoption of the euro
• Lessons for Bulgaria

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WHAT DO NEW MEMBER STATES BRING TO EU?

• Lower income and price level than the euro area
  countries
• Low capital bases
• Large capital inflows
• Rising real exchange rates
• Low bank intermediation
• Large general government deficits (except
  Estonia, Latvia, Lithuania, Slovenia)

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NEW MEMBER STATES STRATEGIES TOWARDS ERM II AND
THE EURO

• Within new member states we have two groups of
  countries
• First group (Estonia, Lithuania, Slovenia,
  Latvia, Malta and Cyprus) - targeting euro
  adoption in 2007-2008. Small open economies,
  fixed exchange rates, good fiscal stance and low
  public debt (except Malta and Cyprus).
• Second group (Poland, Hungary, Czech Rep. and
  Slovak Rep.) - targeting euro adoption in 2010 or
  later.

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FRAMEWORK FOR DECISION ON THE TIMING OF THE EURO
ADOPTION

• Do long-term benefits outweigh the long-term
  costs
• What policy and institutional changes are
  required
• How long will take to put needed policies in
  place in order to fulfil Maastricht criteria

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DO LONG-TERM BENEFITS OUTWEIGH THE LONG TERM COSTS

• Benefits
• Gains from trade (Frankel and Rose, 2002 Micco
  et.al.,2003 Faruqee, 2004 Baldwin, 2005)
• Elimination of exchange rate risk should lower
  real interest rate
• Elimination of exchange rate volatility should
  increase FDI
• Euro adoption will reduce transaction costs
• Joining the Euro area would secure a clear
  framework for macroeconomic discipline
• Costs
• Lack of independent monetary policy
• Exchange rate as a shock absorber

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TRADE GAINS AN EXAMPLE
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WHAT POLICY AND INSTITUTIONAL CHANGES ARE REQUIRED

• Policy changes
• No need to change exchange rate policy problem
  of double regime shift
• Current fiscal policy is consistent with euro
  adoption fiscal balance or surplus ensure room
  for manoeuvre of the policy makers. Harmonization
  of indirect taxes has to be consistent with
  fulfilment of the inflation criteria
• Institutional changes
• Central bank independence, legislative
  requirements for integration into the Eurosystem
• BNB capacity to participate in formulation and
  implementation of single monetary policy
• Euro changeover

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HOW LONG WILL TAKE TO FULFIL MAASTRICHT
CRITERIA FISCAL POSITION
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HOW LONG WILL TAKE TO FULFIL MAASTRICHT
CRITERIA PUBLIC DEBT
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HOW LONG WILL TAKE TO FULFIL MAASTRICHT
CRITERIA INTEREST RATES
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HOW LONG WILL TAKE TO FULFIL MAASTRICHT
CRITERIA INFLATION
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WHY INFLATION CRITERIA IS THE MOST DIFFICULT TO
FULFIL

• No independent monetary policy
• No absolute control of inflation
• No complete inflation convergence for example
  USA inflation among states
• Balassa-Samuelson effect
• Reaction to supply shocks
• Different exchange rate pass-through
• Microstructure of good markets pricing power
• Consumer preferences
• Measurement problems
• Definition of inflation criteria

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RELATIVE PRICE LEVEL AND REAL GDPEU25100, 2004
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RELATIVE PRICE LEVEL AND REAL GDPEU25100, 2004
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REACTION TO SUPPLY SHOCK AN EXAMPLE
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DEFINITION OF INFLATION CRITERIA

• Average rate of inflation, observed over a
  period of one year before the examination, that
  does not exceed by more than 1½ percentage points
  that of, at most, the three best performing
  member states in terms of price stability
• In 2004 ECBs Convergence Report - average of
  three lowest non-negative inflation rates plus
  1.5 percentage points
• Currently means criterion is 2.4 percent (August
  2005)
• Is there room for convergence?

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DEFINITION OF INFLATION CRITERIA
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DERIVED INFLATION CRITERIA AND EURO ADOPTION
CANDIDATES
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INFLATION CONVERGENCE IN EU
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INFLATION CONVERGENCE IN EURO AREA
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VULNERABILITIES ON THR ROAD TO EURO

• Capital account volatility
• Underlying differences in capital-labor ratios
  will remain large return over investment should
  remain high or even rise
• Convergence play during the run-up to euro
• Success carries its own risks improve
  confidence and reduced risk premia
• Large current account deficits
• Financial market integration and goods market
  integration lead, in the poorer countries, to
  both a decrease in saving and an increase in
  investment (Blanchard and Giavazzi, 2002)

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VULNERABILITIES ON THR ROAD TO EURO

• Risks for lending booms
• Inflation is somewhat above euro area implying
  low real interest rates
• In the past households were liquidity-constrained
• Expectations of fast income convergence after EU
  accession
• Terminal date risk
• Risk from policy inconsistency

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SAVING INVESTMENT BALANCE
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CURRENT ACCOUNT AND FOREIGN DIRECT INVESTMENTS
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CREDIT TO THE PRIVATE SECTORPercent of GDP, 2004
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BANK INTERMEDIATION AND GDP1995-2004
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BANK INTERMEDIATION AND GDP1998-2004
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Thank you very much indeed