BULGARIAN ECONOMY ON THE ROAD TO EU AND EMU MEMBERSHIP IVAN ISKROV I would like first to express my sincere thanks to Governor Garganas for the invitation extended, and the opportunity provided to me to talk on the development of the Bulgarian economy before such an esteemed audience. On the verge of Bulgaria s membership in the European Union, I have chosen as the subject of my presentation the path that our society and economy went from the beginning of the transition from a centrally planned to a market economy, and about our plans for full-fledged membership in the Economic and Monetary Union (EMU). To be able to outline for you a clearly-cut picture of the road we went so far and to come to an evaluation of the results achieved, I should first describe in short the initial conditions the Bulgarian transition started from. I. Initial conditions after the collapse of the communism and prerequisites for successful transition Probably most of you know that before the market reforms launched in 1991, the Bulgarian economy, like the other economies of Eastern and Central Europe, was based on the principles of central government planning. There were no commodity, labour and financial markets. These economies were highly integrated among themselves within the Council for Mutual Economic Assistance (CMEA) according to an administratively regulated specialization in specific industries. The existence of guaranteed markets within the CMEA isolated these economies from any competitive pressure and brought the incentives for seeking competitive advantages to a minimum. In the early 1990s a unique transition process from a centrally-planned to a market economy started in the post-communist countries. It was unique because we could not draw on the historical experience of other countries, nor could we rely 1
on the research in the academic literature, because literature on these issues did not exist. We all had to learn ad-hock. Each post-communist country could to a different extend implement reforms that would, quickly and with low social costs, improve the welfare of its society. Regretfully, the Bulgarian society could not achieve, as quickly as the other Central European countries, a consensus and set its priorities, thus allowing for the implementation of quick and efficient pro-market reforms. In the early 1990s, the Bulgarian economy had at its disposal an obsolete physical capital and an outmoded organization of business activities. The changes that had to be implemented for the transformation of the economy from a command into a marketoriented one, required the quick renovation of physical and human capital. Due to various reasons (primarily lack of political will and consensus), however, the restructuring was continuously postponed, hence we paid the high price of a long period of stagnation and economic instability. In the conditions of a prevailing state-ownership, high inflation and quickly changing relative prices, the companies refrained from investments, and this slowed down considerably the pace of replacement of capital assets. In the mid-1990s our country inevitably lapsed into a deep political, economic, and financial crisis. Crises, however, can serve as a catalyst for comprehensive economic reforms. II. Bulgaria Current macroeconomic and financial framework at place in Underlying the economic reform of mid-1997 was the achievement and maintenance of macroeconomic stability, the State s maximum withdrawal from the business, the full liberalisation of domestic and foreign trade, and the introduction of free movement of capitals. The implementation of the Currency Board Arrangement in mid-1997 by fixing the national currency to the German Mark (and since 1 January 1999 to the Euro) and prohibiting any lending by the BNB to the government and the commercial banks in whatever form was a milestone of the economic reform, along with the large-scale privatisation of state-owned assets. At the time of introduction of the currency board, the US Dollar was the major foreign currency dominating the country s foreign trade and was used by the population as a means of saving. The 2
selection of the German Mark (respectively the Euro) as the reserve currency reflected rather the consensus in the society and the political class, that Bulgaria s accession to the EU is the political project around which our energy and efforts should unite. Countries with a currency board are viewed as mechanically importing the monetary policy as well as the credibility of the country or area to whose currency they peg their own currency. This is true, of course, but only to a limited extent. The truth is that you can obtain credibility on credit only temporarily. In the final run, credibility should be won through a consistent and responsible policy. That is exactly why repudiating the implementation of an independent monetary policy requires to orient one s fiscal policy towards supporting the fixed exchange rate regime and to pursue structural reforms that would enhance the economy s flexibility and competitiveness. The fiscal policy implemented since 1997, as well as the liberalization and restructuring of the economy were the main pillars, on which the confidence of the population and of foreign investors were built. The fiscal policy, consistently pursued since 1997, based on a balanced budget or a budget surplus helped the government to bring this parameter to levels far below the criterion adopted by the EU. This resulted in a significant improvement of the country s credit rating, decreasing the sovereign spread, reducing the cost of the credit and improving the investment opportunities. The stringent macroeconomic policy framework adopted, and the structural policy aimed at privatization of state-owned enterprises and market liberalization inevitably brought to significant changes in the real economy. Since 1997, our economy has been on the rise at relatively high growth rates, which have been accelerating as a result of the microeconomic reforms already in place, and due to the country s forthcoming accession to EU. The main factors underlying this economic growth are the growing investments and household consumption, and to a lesser extent - exports. The macroeconomic stability, the privatisation and liberalisation of the economy, as well as the high degree of predictability of the pursued policy, significantly improved the incentives for investing into the Bulgarian economy. From 1999 to 2005, the amount of foreign direct investment is sustained at 8.5 % of GDP as an annual average, and only one third of these investments are generated by privatization deals, the remainder being green-field investments. This process of massive capital inflow accelerated considerably in the recent three years due to the 3
favourable international situation and the approaching full-fledged EU membership of our country. As a result of this, the growth rate of investments increased, as well as their share in the GDP up to 28% in 2005 thus reaching the highest level since the beginning of economic reforms in the country. The high investment levels inevitably brought about an increase in the productivity of labour with a moderate increase in the salaries and wages and the unit price of labour, which allowed our exports to sustain their competitiveness and our country to continue attracting direct investment. At the same time, the growing economic activity was accompanied by a stable growth of employment and the consequent reduction of unemployment. The growth of disposable income of households resulting from the increased employment and salaries was the initial stimulus, which set the beginning of the stable growth rate of consumption in the economy. Subsequently, this effect was considerably reinforced by the development of the domestic banking sector and the enhanced access of households to the credit market. The eased up access to the credit market combined with the decreasing interest rates due to the country s higher credit rating and the global excess liquidity in the recent three years resulted in a reduction of households savings and growth of consumption. The reduced savings of households and companies accounted for by the growth of consumption and investments, inevitably resulted in the accumulation of a current account deficit. The budget surpluses maintained by the government in the recent years managed to some extent to set off the reduced savings in the private sector. Given the latter s significant share in the domestic economy, however, (70% of GDP is generated by the private sector), this policy can have only a limited effect on the country s external position. III. policymakers Economic and monetary developments and challenges for the As a result of the above discussed processes, the current account deficit increased, reaching levels above 5% of GDP in 2003 and 2004, and additionally grew to 11.9% at end-2005. Significant role in the development of our country s current account deficit in 2005 was played by two groups of factors. First, the already mentioned investment growth was accompanied by an increase of imports of investment goods. In 2005, the imports of this group of goods grew by 31.2%, and their share in the overall composition of imports reached up to 28%. This trend was combined with the downward trend in the growth of non-energy raw materials 4
and consumer goods. In the last year, a number of one-off factors had considerable effect, comprising the abrupt increase in the prices and volume of crude oil and the massive floods in the country which hindered exports in the third quarter of the year. It is a well-known fact that the current account deficits are highly inert, which presupposes that reducing the country s external disbalance will be a gradual process. In addition, the Bulgarian economy is at the initial phase of its convergence, which means a longer period with high growth rate of investments and capital inflows. As I have already mentioned, in the recent several years large volumes of capital were channelled into the country, and the banking system acted as the natural intermediator for the efficient distribution of these resources. This is not at all surprising, given the process of privatization and restructuring of the Bulgarian banking sector. Presently, 99.7% of the banking sector is private, and over 80% of the banks in Bulgaria are owned by foreign investors prevailingly from euro area member states. As a consequence of the strong competition and the good investment opportunities, the growth rates of credit to the private sector have increased to the level of 48.6% at end-2004. In several years only, the ratio of bank credit to GDP has grown from 12.1% in 1999 to 45.0 % as of end-2005. Of course, these dynamics reflected to a great extent the process of our economy s convergence, and in particular the intensification of financial intermediation to the levels evidenced in EU member states (112% of GDP). This process was propelled not only by corporate behaviour. Households were also very quick to react to changes by reducing their savings and increasing their propensity to consume now, as a result of their expectations of higher future incomes. These are natural developments though entailing risks that had to be evaluated and measures had to be taken for their minimization. The BNB had to determine the point in time, after which convergence develops into a self-propelling process of struggling for a market share. Such a transition entails considerable risks, as it leads to no sustainable rates of growth both in terms of financial intermediation, and economic activity and employment. Therefore, from the beginning of 2004 the BNB started a process of phasing in of measures (mainly supervisory and administrative) aimed at slowing down the pace of growth of banking credit to a sustainable level, which would not pose significant risks to the stability of the economy. The data indicate that the central bank s policy changed the behaviour of commercial banks. Credit growth rates fell to 32.4% at end-2005, which also stopped the process of depleting the banking system s capital adequacy. This year, by keeping the current measures in 5
place, we expect that the banking credit would grow at a rate lower than, but close to, 20%. A very large part of this audience consists of representatives of commercial banks which operate in Bulgaria or plan to come to our financial market, so I should say that the BNB already began to gradually loosen the current administrative restrictions on the growth rates of banking lending (the so-called credit ceilings ). This policy is needed because during our country s integration into the EU, the commercial banks regulated by the BNB and those regulated by the supervisory authorities of the other EU countries will be placed on an equal footing. However, the gradual removal of the administrative restrictions on banking lending should not be viewed as a BNB policy aiming to relax the current stringent regulatory framework which limits the risks in the banking system. The strict supervisory framework introduced and applied by the BNB will remain unchanged. IV. EU and EMU perspectives By signing the Treaty of Accession to the EU, Bulgaria made the commitment to join the Euro zone and introduce the single currency. The current European legislation does not allow the new EU member-states to use an opt-out clause for their membership in the EMU. This means that after becoming a member of the EU, Bulgaria will have to decide not if it would join the EMU and introduce the single currency, but when and how this should be done. The European legislation does not provide any explicit date for the Euro introduction or a period for complying with the convergence criteria. Moreover, the European Central Bank (ECB) and the European Commission (EC) decided that they could not accept the currency board arrangement as a substitute for the participation in the Exchange Rate Mechanism II (ERM II), but that the ERM II did not rule out the unilateral operation of a currency board arrangement in the countries where this arrangement already exists. Having in mind what was said above and the principles of the macroeconomic policy pursued in our country, with a currency board arrangement based on the Euro, in 2004 the Government and the central bank signed an agreement whose purpose is the only logical decision the introduction of the Euro in the shortest possible time horizon. This document describes Bulgaria s strategy for membership in the EMU and this strategy is based on the following principles: 6
Joining the Exchange Rate Mechanism II (ERM II) as soon as possible after the date of Bulgaria s official membership in the EU (probably in the first quarter of 2007). Keeping the currency board in place until we join the Euro zone, with the current fixed exchange rate of the Bulgarian Lev to the Euro - 1.95583 BGN for 1 Euro; The unilateral commitment of the Bulgarian Government and the BNB to maintain a zero fluctuation of the exchange rate from the fixed level (i.e. carrying on the present policy of maintaining the currency board arrangement); Meeting the minimum period set in the EU legislation for participation in the ERM II and taking in time all the necessary steps of the procedure for membership in the Euro zone. This strategy is very similar to the way of introducing the single currency adopted by some of the old member-states (e.g. Austria) and by Estonia and Lithuania the two countries having currency boards, which joined the EU in 2004. The agreement between the BNB and the Government on Bulgaria s policy for our membership in the EMU largely decreases the uncertainties about the macroeconomic policy and provides predictability, facilitating entrepreneurs and households in formulating their objectives. This strategy is too ambitious but attainable. Following the current policy of balanced budget, with a surplus if possible, will enable us to meet the Maastricht criteria in terms of budget deficit, government debt and long-term interest rates, and will also make the macroeconomic policy more responsive and flexible. It is well known that under a currency board arrangement, the fiscal policy is the only tool available for a relatively quick response to adverse developments in the economy of the country. Furthermore, in order for us to have this flexibility with the growing current account deficit and rapidly increasing private debt, in periods like this where the economy is growing at rates close to or a little above the long-term growth rates, the budget needs to compensate by generating a sufficient surplus. The tough fiscal policy is needed also because it will help us comply with the inflation criterion. Operating under a currency board arrangement, the central bank has no direct control of inflation rates in the country. Practically, this particular criterion will be the biggest challenge for us. Given the current trend of price levels 7
in the new member-states converging to the levels in the old member-states (a result of the well-known Balassa-Samuelson effect), this criterion is a challenge not just for the countries with a currency board in place, but also for all countries with price levels lower than the average in the EU. The very definition of the inflation criterion, i.e. inflation not higher than the average of the three lowest rates of inflation in the EU plus 1.5 percent, creates some uncertainty. The ten new member-states, as well as Bulgaria and Rumania, find themselves in a shooting at a moving target situation. At the same time, with the 25 member-states (27 with Bulgaria and Rumania) it is very likely that we would have three countries, the socalled best performers, with rates of inflation close to zero because of cyclic or other specific for those countries reasons. This means that the inflation criterion would be very strict and would require reaching inflation rates close to or even lower than the ECB inflation target (lower, but almost 2 % inflation). Considering this strongly restrictive inflation criterion and the uncertainties about determining its level, we expected that the ECB and the European Commission would show greater flexibility in assessing the compliance with this criterion. Unfortunately, Lithuania s assessment published in the Convergence Report in May this year suggested that the expected flexibility would not be demonstrated. A very bureaucratic approach has been used, neglecting the fact that each economy is affected by a large number of internal and external influences and this very much hinders the fulfilment of the heavily restrictive inflation criterion, especially with the absence of an autonomous monetary policy. In the particular case of Bulgaria where a fixed exchange rate regime is in place together with a very conservative fiscal policy, reserves should be looked for in promoting the competition and improving the business environment so that the economy would have greater flexibility to respond to changes in the external environment (including raw materials prices), and the supply could react faster to the increased demand (internal and external). Last year inflation reached 6.5%, and the increase in energy prices was a strong inflationary factor (its direct contribution is 1.0% of the overall price rise). In addition, the heavy floods led to an unexpected rise in foodstuffs prices (a contribution of 2.6% of the overall price rise). This year we expect that inflation would fall to 6.0% in spite of its faster growth rates over the first two months of the year. The slow process of decreasing the inflation rate is largely determined by the harmonisation of indirect taxes, undertaken early this year, with the EU minimum levels. As the changes in indirect taxes and administered prices directly affect the inflation in the country, their catching up 8
adjustment has to take place before the years that will be the basis for assessing the compliance with the Maastricht criteria before 2008. From this perspective, the ahead-of-time harmonisation of some excise duties is a step that would very much help for the compliance of the inflation criterion because it would eliminate the inflationary influence caused by the increase in these taxes over the years that will be used for the assessment. V. Conclusions Before I finish, I would like to point out the regional factor for the successful development of the Bulgarian economy and the role of Greece. I have already mentioned that in the early 1990s Bulgaria began the transition from a centrallyplanned to a market economy, and in the mid-1990s we went through a profound political, financial and economic crisis. Throughout this period the Greek business and political elite supported the efforts of the Bulgarian society to handle these challenges. After the economic stabilization in 1997 the Greek businesses were among the first to provide credit of confidence to the Bulgarian economy, investing in the banking sector of the country and in a number of other important sectors of the economy. At the end of 2005 the commercial banks with Greek share participation held 19% of the capital of the Bulgarian banking system, 18% of its total assets and deposits, and 22% of the lending to the private sector. Through the capitals that they are investing and the transfer of knowledge and expertise, these institutions have a major contribution to the economic growth in our country. Apart from that, the Greek business is the second largest direct investor in Bulgaria by 12.4% of the foreign direct investments made in Bulgaria from 1999 until now. Greece leaves far behind much larger in size economies, such as Germany, France and Italy. The intense investment activities of the Greek businesses in Bulgaria definitely affect the direction of our foreign trade flows. Greece is the third most important trading partner of our country, holding 12.9% of our foreign trade in 2005. The accession of Bulgaria and Rumania to the EU and the prospects for membership of the other countries in this region, give the Balkan countries a chance for full integration into the world economy. We can say without hesitation that the countries in this region have never before had a chance like this in their history. By developing the regional cooperation and promoting the political and 9
economic ties between our countries, the Balkan region can become competitive not only within the EU but also in the global economy. Finally I would like to express my highest appreciation of and gratitude for the steady and consistent support given by Greece and the Greek elite for the reforms in Bulgaria and especially for our accession to the EU. This support is very well known in the Bulgarian society. We do hope that this friendship and assistance will continue during Bulgaria s accession to the Euro zone and afterwards. 10