Bulgaria: Challenges of convergence to EMU Nikolay Nenovsky University of National and World Economy Bulgarian National Bank

Sofia, UNWE - KIA, 3/05/2007 Topics to discus What is convergence and why convergence is necessary? Relationships: convergence, economic cycle and monetary regime Two historical remarks on convergence Some theory of convergence Bulgaria: some facts of convergence Bulgaria: some problems of convergence

Sofia, UNWE - KIA, 3/05/2007 Why convergence is necessary? Convergence: process according to which the differences between countries' main characteristics become smaller and eventually disappear with the time … Why convergence? Readiness to adopt common monetary policy (ECB) and common currency (Euro) Synchronization of economic cycle, catch-up EU Similar transmission channels of Monetary policy Similar reaction to EU shocks Appropriate mechanisms of shocks absorption (openness, flexible markets, free movement of goods, K, L, budget transfers etc.)

Sofia, UNWE - KIA, 3/05/2007 Convergence of economic cycle

Sofia, UNWE - KIA, 3/05/2007 Some theory and empirics of convergence Maastricht criteria (static) (ST: inflation, public deficit, exchange rate; LT: public debt, long term interest rate) Econometric measuring (dynamic) of convergence:  convergence (the variable of the poorer country advance faster that of richer country and catch-up with them)  convergence (means dispersion between the variables in the rich and the poor countries decreases with time) Conditional convergence: local (versus absolute) absolute local

Sofia, UNWE - KIA, 3/05/2007 Convergence and monetary regime Economic approach: from real economy convergence to the adoption of common currency (ex: big countries, low inflation countries, Germany) Monetarist approach: from common currency to real convergence (ex: small countries, inflation-prone economies, South Europe, Bulgaria) Actually: compromise (since Delors)

Sofia, UNWE - KIA, 3/05/2007 The basic ideas of the Monetarist approach Common currency: strong stimulus for real convergence Stimulate real convergence via trade integration (endogenous currency area) Transaction cost reduction, Exchange rate risk elimination, low interest rates, high investment etc. Low probability of twin crisis Help to build hard budget constraints, “culture of discipline” and higher credibility External monetary anchor for small open economy

Sofia, UNWE - KIA, 3/05/2007 The monetarist approach in Bulgaria: the Currency board Institutional solution after the crisis (1997) Exchange rate fixed by low (since 1997) Full coverage of monetary base (imitation of the gold standard, automatic mechanism etc.) Limited monetary policy tools (RR) and limited LLR High transparency, credibility and discipline Quasi Euro area – import ECB monetary policy

Sofia, UNWE - KIA, 3/05/2007 Remembering: the balance sheet of Bulgarian Central Bank ASSETSLIABILITIES CashCurrency in circulation Monetary goldBank deposits (R = RR+RE) Foreign securitiesGovernment deposits and accounts (Fiscal reserve) Banking Department deposit (Net value of Currency board) Total 8.6 b euro ASSETSLIABILITIES Non monetary gold and other precious metals Borrowings from IMF Investment in securitiesLiabilities to other international financial institutions Loans and advances to banksCapital Claims on governmentReserves Bulgarian’s IMF quota and holdings in other international financial institutions Retained profit Deposit with Issue Department Issue department Currency board Banking department

Sofia, UNWE - KIA, 3/05/2007 Historical remark on convergence (1) Industrialization: economic growth in Europe (%, annual) Gold standard is the best period for growth Western South Oriental Europe Europe Europe GDP 1820– – Population 1820– – GDP per capita 1820– – [1870–1910] Source: A. Maddison (1995), Good D., T. Ma (1999)

Sofia, UNWE - KIA, 3/05/2007 Historical remark on convergence (2) GDP level in Europe 1913 – 2003 (%, annual), UK = 100 Source: Landes, D. (2000), OECD (2005)

Sofia, UNWE - KIA, 3/05/2007 Some facts on convergence – real growth

Sofia, UNWE - KIA, 3/05/2007 Some facts on convergence – Long term interest rates

Sofia, UNWE - KIA, 3/05/2007 Some facts on convergence – price level Comparative price levels of final consumption by private households including indirect taxes (EU-25 = 100)

Sofia, UNWE - KIA, 3/05/2007 Some facts on convergence – inflation

Sofia, UNWE - KIA, 3/05/2007 Some facts on convergence – monetary aggregate

Sofia, UNWE - KIA, 3/05/2007 Some facts on convergence – credit growth

Sofia, UNWE - KIA, 3/05/2007 Some facts on convergence – public finance Decreasing levels of public debt (22.8% of GDP as end-2006) Budget surplices in last years (3.3% of GDP as end-2006)

Sofia, UNWE - KIA, 3/05/2007 Some facts of convergence – productivity GDP in Purchasing Power Standards (PPS) per person employed relative to EU-25 (EU-25 = 100) Some preliminary conclusions from the different studies (including econometrical) on Bulgaria: High nominal convergence (Currency board) Low real convergence

Sofia, UNWE - KIA, 3/05/2007 Labor productivity per person employed GDP in Purchasing Power Standards (PPS) per person employed relative to EU-25 (EU-25 = 100) Source: Eurostat

Sofia, UNWE - KIA, 3/05/2007 Some problems of convergence Convergence and development – enemies or friends? Does poor countries (catch-up countries) need the same cycle and the same institutions like in the rich countries? Who drives the convergence? Market driven convergence State driven convergence The challenge of institutional convergence? Where are the limits of European and National Institutional building? Institutional competition When and how to adopt the euro?

Sofia, UNWE - KIA, 3/05/2007 Strategies of Euro adoption Bulgaria was committed to join ERM II immediately after the date of EU membership, We intend to enter ERM II at current exchange rate – 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 respect SGP principles For new member states there is no opt-out clause for adoption of the single currency, the questions are “when” and “how” Now - decisions to take: the date of entry, the choice of the central rate, the width of the exchange rate band, the length of stay in the mechanism etc – from our point of view is clear.

Sofia, UNWE - KIA, 3/05/2007 Strategies of Euro adoption – the standard procedure

Sofia, UNWE - KIA, 3/05/2007 Strategies of Euro adoption: Currency board versus inflation targeting Inflation targeting needs Central bank credibility Need for good knowledge of the transmission mechanism and good macroeconomic model Need for well defined loss function (output gap) and reaction function (Taylor rule for example) Need for good inflation forecasts (EE never hit the target) Need for very good macro econometric model Need for developed financial markets None of these conditions exists in Bulgaria, Romania or Eastern Europe in general

Sofia, UNWE - KIA, 3/05/2007 Instead of Conclusion: possible sources of Bulgarian influence in EU and EMU decision making Helen Wallace (2003) methodology 7 sources of influence: Political weight (non) Economic weight (non) Political practice (yes) ? Social and economic practice (yes) ? Persuasive ideas (yes) ? Compelling demands (yes) ? Credibility and consistency (yes) – Currency board, fiscal discipline Bulgaria should take the example of the Benelux countries Currency board, fiscal discipline Policy entrepreneur Persuasive ideas Pace-setting role