Macroeconomic and political- economic implications of
stabilisation under a currency board arrangement
Georgy Y. Ganev and Michael L. Wyzan
Introduction
On 1 July 1997, after plunging into one of the post-communist world’s worst crises, Bulgaria introduced a currency board arrangement (CBA) as a means of achieving macroeconomic stabilisation and sustainable eco- nomic growth. This event has implications that go far beyond the standard ones regarding the macroeconomy and external sector. One of the major side-effects of introducing a CBA is a qualitative change in political rela- tionships, and in the rules of the economic game. This is especially true for Bulgaria, where the crisis reflected not only macroeconomic imbal- ances, but also fundamental structural problems, resulting from complex political-economic interactions amongst diverse social actors.
In this essay, we utilise both macroeconomic and political-economic tools to analyse the salient aspects of the crisis and of the immediate, CBA- dominated, post-crisis era in Bulgaria. Whilst it is possible to focus solely on short-run macroeconomic performance under Bulgaria’s CBA, as does most of the literature on CBA, a more important question is the sustain- ability of such an arrangement in terms of both macroeconomic indic- ators and political factors. Any discussion of the broad applicability of CBA at a variety of developmental levels, something which is taken for granted by the CBA’s more enthusiastic proponents (see, for example, Hanke and Walters, 1992; Hanke and Schuler, 1994), must pay attention to the need to generate sustained political support for the arrangement.
Such an analysis is necessary in light of the theoretical arguments accord- ing to which CBA make macroeconomic adjustments more socially painful than under floating exchange-rate regimes (see, for example, Dobrinsky, 2000).
Bulgaria is the clearest case in Central and Eastern Europe of an eco- nomic and political failure to reform caused by the dysfunctional nature of domestic institutions that arose during the post-communist era. Most macroeconomic data (especially inflation, interest rates, investment and, recently, exports and growth of gross domestic product or GDP) suggest
that the Bulgarian CBA has been a success. The rapidity and seemingly decisive nature of the country’s macroeconomic turnaround, however, may obscure relevant political and social processes that affect the regime’s sustainability. No evaluation of the appropriateness of a CBA as a tool for lasting economic improvement would be complete without careful consideration of its political-economic aspects.
We organise this essay as follows. The next section examines the macro- economic aspects of the crisis and the post-crisis era under the CBA. This section is subdivided into three parts: the first deals with the crisis era; the second subsection attempts to provide a balanced assessment of the posit- ive and negative consequences of the introduction of the CBA for the macroeconomy and the external sector; the third subsection evaluates the relevance for Bulgaria of a number of problems that have been associated in the literature with the operation of CBA. The third section deals with the political-economic aspects of the crisis and its roots, presenting a first attempt to come up with a political economy of a transition economy under a CBA. The final section discusses the sustainability of current Bul- garian institutions.
Macroeconomic policy and performance before and after the introduction of CBA
Macroeconomic performance during pre-CBA era
A number of authors (see Dobrinsky, 1996; Dobrinsky, 1997; Wyzan, 1998;
Balyozov, 1999; IMF, 1999; OECD, 1997, 1999) describe and analyse the economic crises in Bulgaria before the introduction of the CBA. Our purpose here is not to provide a detailed description of these crises, but to outline briefly the main macroeconomic developments. A stylised picture of the situation and its dynamics before the introduction of the CBA would have several main elements.
First, there were large macroeconomic imbalances inherited from the previous era, when the Bulgarian economy experienced distortions that were generally more severe than in other socialist-bloc countries (Dobrin- sky, 1997). This meant that a rapid transition towards ‘authentic’ (a term coined by Avramov and Guenov, 1994) market behaviour was problematic, if not impossible. As a consequence, there were repeated waves of smaller or larger crises related to the effects of these imbalances on the economy.
Second, Bulgaria was amongst the significant losers from the dissolu- tion of the Council for Mutual Economic Assistance, from which it had benefited under the international socialist planning system. It also lost important markets in Russia, Iran, Iraq and Libya. International sanctions against Iraq and Libya effectively froze the servicing of more than $2,000 million of their debt to Bulgaria. Sanctions against the former Yugoslavia damaged trade flows and fostered criminal activity.
Third, the lack of hard budget constraints and the will to implement structural reforms aimed at introducing market competition led to the accumulation throughout this era of fiscal and quasi-fiscal deficits. This problem manifested itself in losses at large state-owned and even private enterprises,1the build-up of bad debt towards many (mostly state-owned) banks and the bailing out of these banks through acts of parliament. This process, punctuated by the occasional ‘fiscalisation’ of quasi-fiscal deficits, underlines the whole macroeconomic dynamic of the era between 1989 and 1997. Parliament adopted such legislation in 1991, 1992 (both of which were for relatively small bail-outs) and 1993 (the now infamous ZUNK bonds; see Wyzan, 1998, p. 8), and in 1996 it passed deposit- guarantee legislation in the face of a severe banking crisis.
In addition to their occasional ‘fiscalisation’, the Bulgarian National Bank (BNB) more or less continually monetised quasi-fiscal deficits through the provision of generous, often unsecured loans. Dobrinsky (2000, p. 3) sees this process as an example of ‘fiscal dominance’, which
‘denotes a mix in which primary deficits do not respond to the level of government debt in a systematic way and hence monetary policy has to correct for that in order to prevent a public debt crisis’. The BNB’s policy was principally to accommodate these deficits, its only constraint being the size of the foreign reserves. The government had a short-term interest in seeing deficits monetised, a practice that took two basic forms. These were central-bank purchases of treasury debt, and the setting of low-base interest rates so as to decrease the burden of government domestic-debt service. Movements in the foreign reserves, however, depend on the domestic and foreign public’s perceptions of the desirability of holding Bulgarian currency, which in turn reflect the fiscal position of the govern- ment and current and expected interest rates. Thus, the foreign reserves would start falling whenever it became obvious that the combination of the fiscal position, including the quasi-fiscal component, and interest-rate spread between the lev and foreign currencies could not sustain the current exchange rate. Ultimately, these runs on the reserves resulted in currency crises.
Accordingly, any stylised description of the first eight years of the Bul- garian transition must mention the series of ‘fiscalisation’ and monetisa- tion crises and the periods of relative macroeconomic calm between them.
A look at the dynamics of inflation, real and dollar wages and the real exchange rate clearly shows an alternation of crises and relatively unevent- ful periods (see Figures 8.1, 8.2 and 8.3). Table 8.1 contains a brief description of the main periods during this era.
Macroeconomic performance during CBA era
The importance of the CBA for Bulgarian macroeconomic dynamics after the crisis of 1995–1997 necessitates a brief description of the nature of
Percentage 30 25 20 15 10 5 0 5
1990–061990–121991–061991–121992–061992–121993–061993–121994–061994–121995–061995–121996–061996–121997–061997–121998–061998–121999–061999–122000–062000–122001–062001–122002–062002–122003–062003–12 Year
Figure 8.1 Bulgarian monthly consumer-price index.
Note
Values of the index for February and March 1991, and January and February 1997, are 123.49 and 242 per cent, respectively.
120
Index, January 1991 100
250
0 20 40 60 80 100
0 50 100 150 200 US dollars/month
1991–011992–011993–011994–011995–011996–011997–011998–011999–012000–012001–012002–012003–01 Real wage (CPI)
Dollar wage
Figure 8.2 Bulgarian real and dollar wages.
such an arrangement. In principle, a CBA is an arrangement under which the growth of the monetary base is automatically tied to changes in the foreign reserves. The monetary base must be backed at all times at least 100 per cent by foreign reserves. The institution serving as a CBA is pro- hibited by law from holding domestic assets. It cannot make loans to the government or to commercial banks, so domestically generated changes
Table 8.1 Periodization of pre-CBA era in Bulgaria
Period Description Main events
February– Good start on First IMF stand-by (February); reform November 1991 stabilisation and programme involved price liberalisation,
liberalisation floating, unified exchange rate, foreign- trade liberalisation, incomes policy, fiscal reform; tight monetary policy; general elections (October) result in reformist coalition between Union of Democratic Forces (UDF) and ethnic Turkish party November 1991– Abortive attempt First UDF government: inflation steady at October 1992 to initiate 4–5% per month, unemployment
structural change continues to rise from 9% to 15%, real appreciation of lev, foreign reserves rise from $300 million to $900 million (not servicing foreign debt yet); second IMF standby (April); important structural- reform legislation: foreign-exchange law, privatisation law, law on agricultural land ownership and use
December 1992– Treading water Uneventful regime of Berov (with tacit December 1993 until first currency support of socialists) begins; trough of crisis transformational recession seems to be reached: unemployment peaks at 16.5%
(January 1994); biggest trade and current- account deficits in 1993; inflation on downward trend; significant real appreciation of lev; monthly dollar wage peaks at $128 (September); BNB lowers base interest rate (June, August), and international reserves fall from $1 billion (October 1992) to $600 million (January 1994); large fiscal imbalance; IMF never releases fifth tranche of April 1992 stand- by (no IMF credits, April–December 1993) January– First currency Large depreciation of lev (US$33 in May 1994 crisis December 1993 – US$56 May 1994);
surge in inflation (especially in April);
crisis had few if any real sector effects (unemployment continues decline, GDP grows slightly in 1994), as IMF approves standby (April, after VAT introduced) and foreign reserves recover
Table 8.1 continued
Period Description Main events
June 1994– Calm between Debt reduction and rescheduling June 1995 storms agreement with London Club, as IMF,
pleased with monetary and fiscal policy, approves special support for agreement (September); deceptive improvement in macroeconomic performance: CPI inflation and unemployment falling, GDP growth picking up slightly, dollar wages rising, almost balanced trade and current accounts, lev nominally stable, foreign reserves rise, despite large foreign-debt service (1994 and 1995) and no new IMF funding (September 1994–July 1996);
Berov regime resigns (October), socialists take power (January); but absence of structural reform and problems accumulating
June 1995– Second currency First sign of trouble: foreign-reserve February 1997 crisis and economic meltdown ($1.5 billion in June 1995 to
collapse $480 million in July 1996) and
consequent weakening of leva (US$71 in January 1996 to US$488 in January 1997);
socialist regime tries to deal with
structural problems (liquidation or credit cut-off for troubled large enterprises, bankruptcy for insolvent banks) and IMF approves standby (July 1996), but poor policy (e.g. illiberal price and trade regimes) continues and IMF does not release later tranches of stand-by, with foreign reserves falling to $381 million (January 1997); performance collapse, as of February 1997: 243% monthly CPI inflation, lev hits 2,937 to US dollar (12 February), monthly dollar wage under
$25, run on banks resulting in many bankruptcies; socialist government resigns (December 1996), UDF caretaker government (February 1997), elected majority UDF government (May 1997)
in the monetary base are not possible. Moreover, the nominal exchange rate of the domestic currency against a reserve currency – in the case of Bulgaria, initially the Deutsche mark and later the euro – is indefinitely fixed by law, and economic agents are allowed to freely convert unlimited amounts of domestic currency into reserve currency at that rate.
A major macroeconomic implication of a CBA is that, in principle, the domestic inflation rate converges towards the inflation rate in the reserve country. Due to the nominal exchange-rate peg, adjustments to shocks affect the economy through the balance of payments in a manner similar to the operation of the gold standard. For example, domestic inflation higher than in the reserve country results in a real exchange-rate apprecia- tion, which may lead to a deterioration in the current-account balance, and a slowdown in economic growth, accompanied by downwards pressure on prices. Such inflation is particularly likely in less developed and transition countries, where there is relatively fast growth of productivity in the pro- duction of tradables (the Balassa–Samuelson effect). Neither theory nor practice suggests that there should be a rapid convergence of the domestic inflation rate towards the inflation rate in the reserve country.
The Bulgarian CBA differs somewhat from the orthodox version (see Dobrev, 1999). The central bank continues to exist and is divided into three departments: Issue Department, Banking Department and Bank Supervision Department. The Issue Department plays the role of a CBA, although in addition to the monetary base, its liabilities also include a deposit holding the fiscal reserve of the government and a deposit of the Banking Department. The central bank also has the ability to affect com- mercial-bank operations by setting minimum reserve requirements and
Index, March 1991 100
400
0 50 100 150 200 250 300 350
1990–121991–061992–061991–121992–121993–061993–121994–061994–121995–061995–121996–061996–121997–061997–121998–061998–121999–061999–122000–062000–122001–062001–122002–062002–122003–062003–12 Year
Figure 8.3 Real exchange rate, Bulgarian lev vs US dollar (downward movement indicates depreciation of lev).
supervising commercial banks. The existence of the government deposit and the possibility of setting reserve requirements allow for what Nenovsky and Hristov (1998) call ‘quasi-monetary policy’.
Bulgarian macroeconomic indicators after the introduction of the CBA show signs of significant stabilisation. Despite the relatively short time since the introduction of the CBA, we can tentatively divide the era into three periods, based largely on trends in quarterly year-on-year GDP growth (see Figure 8.4). The first period is the initial recovery from the trough of the 1995–7 crisis, with impressive growth of 18.3 per cent in the first quarter of 1998, which largely reflected a very low base.
During the second period, which started in the third quarter of 1998 and ended in the last quarter of 1999, quarterly year-on-year GDP was essentially stagnant. The only exception was the relatively strong year-on- year growth in the third quarter of 1999, which can again be explained by the low base set by the weak third quarter of 1998. The period was shaped by two major external shocks – the Russian meltdown of August 1998 and the Kosovo crisis in the second quarter of 1999 – and was also charac- terised by low prices for many Bulgarian export goods (e.g. metals and chemicals). Moreover, it was a time of an apparent slowdown in reforms, manifested in a declining pace of privatisation, delays in the liquidation of insolvent state-owned enterprises (SOEs) and falling public confidence in the will of the government to maintain the reform momentum.
During the third period, from 2000 to 2003, the data suggest a new era of macroeconomic dynamics under the CBA. Exports experienced robust growth, industrial sales and production reversed their decline and posted real growth (initially modest and later robust) and investment steadily served the role of a growth engine. Real GDP growth was above 4 per cent in each of these four years. The liquidation programme for insolvent state-
Percentage
8 7 6 5 4 3 2 1 0 1 2
1997–3 1998–1 1998–3 1999–1 1999–3 2000–1 2000–3 2001–1 2001–3 2002–1 2002–3 2003–1 2003–3
Figure 8.4 Bulgarian quarterly real GDP growth index (YoY).
Note
The value of the index for 1998.1 is 18.3, due to the extremely low base in 1997.1.
owned enterprises, which was supported by the International Monetary Fund (IMF), was fully completed, with about two-thirds of them privatised and the remainder closed by the end of June 1999. This structural policy was one of the main causes of the growth in unemployment in the second half of 1999. After reaching record high levels for the transition period between the spring of 2000 and the spring of 2001, unemployment began a slow but steady decline slowly in 2001 and 2002, with the pace of decline picking up significantly in 2003 (see Figure 8.5). During these years, the Issue Department’s foreign reserves grew by more than 2,000 million euro (over 65 per cent), indicating that the economy has been generating an overall balance-of-payments surplus.
During the CBA era, annual real GDP has posted four consecutive years of modest growth, namely 4 per cent in 1998, 2.3 per cent in 1999, 5.4 per cent in 2000, 4.1 per cent in 2001, 4.8 per cent in 2002 and an expected 4.4 per cent in 2003. More promisingly, real gross fixed-capital formation grew during these years by 16.9, 20.8, 15.4, 23.3, 9.3 and an expected 18 per cent, respectively. Consumer-price inflation (see Figure 8.1) has been brought down sharply from pre-CBA levels, falling from a geometric mean of 7.92 per cent monthly over April 1991–June 1997 to 0.60 per cent over July 1997–December 2003. This era exhibits different consumer price index (CPI) dynamics during each of these three periods. The first period (initial recovery) was accompanied by a geometric mean monthly rate of inflation of 1.77 per cent until April 1998, possibly reflecting inflationary inertia and continuing macroeconomic adjustment in the aftermath of the crisis. The second period (stagnation) coincides with a geometric mean monthly rate of inflation of 0.22 per cent, including a deflationary period in the summer of 1998 and the first half of 1999. During the third period, however, the
Percentage
20 18 16 14 12 10 8 6 4 2 0
1990–121991–061991–121992–061992–121993–061993–121994–061994–121995–061995–121996–061996–121997–061997–121998–061998–121999–061999–122000–062000–122001–062001–122002–062002–122003–062003–12 Figure 8.5 Bulgarian unemployment rate.
pick-up in GDP, production and exports was accompanied by a slight accel- eration of mean monthly inflation to 0.51 per cent.
An interesting issue related to price performance under a CBA – espe- cially in a developing or transition country – is the real appreciation of the currency. Figure 8.6 shows the real exchange rate (based on the CPI) of the Bulgarian lev against the US dollar and the Deutsche mark over the CBA era. The latter is more relevant, because it broadly represents the real exchange rate of the lev against the currencies of the euro-zone coun- tries, which are by far Bulgaria’s most important trading partners. Because of the fixed nominal exchange rate, this index simply tracks the difference in consumer-price inflation rates. Not surprisingly, the higher inflation in Bulgaria over this era resulted in a real appreciation of the lev so meas- ured. The real exchange rate of the lev follows generally the same dynamic over the CBA era as the inflation rate (see Figures 8.1 and 8.6).
The lev’s appreciation is much weaker and more variable when the real exchange rate is calculated against the US dollar (again on a CPI basis).
Although trade is dominated by the euro zone, energy imports (especially from Russia) are denominated in dollars, so the real exchange rate against the dollar continues to be of interest.
Wages, shown in Figure 8.2, have exhibited a dynamic broadly consis- tent with the already outlined periods of the CBA era, especially when measured in US dollars. During the first period, real wages recovered from the exceedingly low levels inherited from the crisis period of 1996–1997, posting a growth rate of 6.5 per cent. The momentum of nominal wage growth continued into the second period, despite price deflation in the first half of 1999 and GDP stagnation. Real wage growth was 13.4 per cent, perhaps contributing to widening external imbalances
Index, June 1997 100
150 145 140 135 130 125 120 115 110 105 100 95 90
US dollar Deutsche mark
2003–12 2003–09 2003–06 2003–03 2002–12 2002–09 2002–06 2002–03 2001–12 2001–09 2001–06 2001–03 2000–12 2000–09 2000–06 2000–03 1999–12 1999–09 1999–06 1999–03 1998–12 1998–09 1998–06 1998–03 1997–12 1997–09 1997–06
Year
Figure 8.6 Real exchange rate, Bulgarian lev, since introduction of CBA (down- ward movement indicates depreciation of lev).