Betraying no signs of euro fatigue after recently concluding intense negotiations on the accession chapters for EU entry, the Bulgarian government announced this week it was preparing a strategy to adopt the euro soon after 2007. While some critics have argued that such thoughts are highly premature, others suggest that of all the EU’s new and prospective entrants, Bulgaria has a better chance than many of swapping its currency for the euro before the end of the decade.
The governor of the Bulgarian National Bank (BNB), Ivan Iskrov, told journalists earlier this week that in October the government and the central bank intend to present a working paper on switching to the euro.
Iskrov then claimed that Bulgaria’s currency, which has been pegged to the euro since 1997, is not overvalued and that the current fixed rate of Lv1.95583 to the euro would continue to be upheld. The governor also said the value of local currency should not be seen as a barrier to the country’s competitiveness and reiterated that Bulgaria intends to switch to the euro before 2010.
In many ways, a kind of “euro-isation” has already begun. Recently, for example, the BNB removed the 0.5% margin in the lev/euro exchange rate for electronic currency transactions. Banks can now change levs into euros and back without paying a commission for the service, a further step towards the euro-isation of electronic transactions.
However, although news that the government aims to join the euro zone as rapidly as possible is likely to reassure investors, given the significant amount of EU implementation work still awaiting the Bulgarian authorities before the country can join in 2007, there is a major question mark over the timeliness of this debate.
Yet a recent report by the Organisation for Economic Co-operation and Development (OECD) suggests that Bulgaria’s preparations for early entry into the euro zone are fully justified. The report says that smaller countries which have been able to sustain hard currency pegs (Bulgaria has since 1997) should be best placed to achieve a smooth and fast transition to European monetary union.
“The strategy based on pegs has supported the small countries’ efforts in significantly advancing convergence in recent years with inflation and interest rates close to those in the euro area,” the OECD concluded.
Bulgaria may in fact have a stronger case for adopting the euro than some new member states, such as Poland, Hungary and the Czech Republic, where the exchange rate still plays an important macroeconomic role as a stabilisation tool. This is the main reason why the Czech Republic, Poland and the Slovak Republic have expressed a wish to delay their participation in the European Exchange Rate Mechanism (ERM II) by two years. This is because during this ERM II period, which serves as a waiting room before euro adoption, they will have to keep their currencies’ exchange rates to the euro within a narrow band, reducing their room for manoeuvre.
In contrast to these new East European members, Bulgaria is expected to ask for a shorter ERM II period, arguing that it has already met most of the euro zone membership criteria.
According to Tahchiev, “Bulgaria follows restrictive fiscal and monetary policy and covers most of the Maastricht criteria. Except for the inflation rate and the interest rate – which are interrelated – Bulgaria is well below all other limits.”
Moreover, Tahchiev explained, “There is a consensus among all political parties to stick to these targets.”
Many Bulgarian policy-makers, whose monetary autonomy was curtailed by the hard euro peg adopted back in 1997, are not worried about giving up their control over the exchange rate. For better or worse, analysts agree that the euro peg has already placed Bulgaria in a quasi-euro zone, with an economy that depends on the euro’s performance against other currencies – notably the dollar. Advocates of accelerated euro zone entry argue that Bulgaria has already had to deal with the negative side of being tied to the euro, without enjoying the full benefits of being in the euro zone.
Meanwhile, the government’s decision to launch preparations for joining the euro is likely to raise awareness of Bulgaria’s macroeconomic achievements – such as a low inflation rate, a good public debt-to-GDP ratio, and well-managed public finances.
Entering the ERM II process immediately after the expected accession in 2007 is likely to lead to a reduction in financial risks and a convergence of interest rates. Ultimately, participation in European monetary union should ensure increased trade, access to capital, lower transaction costs and protection from external shocks – all of which is likely to translate into higher GDP growth.
Still, with a relatively low degree of real convergence with the EU, in terms of the similarity of economic structures and the synchronisation of the business cycle, Bulgaria’s euro zone entry is far from assured.
However, Bulgaria’s ability to meet the main stability pact requirement – keeping the budget deficit under 3.0% of GDP – should also work in the country’s favour. Sofia has succeeded here where others have failed, with budget deficit limits having been the principle bone of contention among the current members of the euro zone for some time now.
The problems of enforcing the stability pact have also provoked calls that the budget deficit requirements of new EU member states should be even more stringent. Robert Mundell, widely considered to be the father of the euro, has even suggested that the deficit criterion be brought close to zero.
While this would create great difficulties for countries such as Hungary, the Czech Republic and Poland (all of them are failing to meet the 3% budget deficit target), Bulgaria might still pass the test though. It has managed over the last few years to stick to impressively low budget deficits, running under 1% of GDP. Its performance in controlling the public finances is one of the best in Central and Eastern Europe, second only to Estonia, which in fact, runs a budget surplus.
In addition, Deputy Finance Minister Lyubomir Datsov told journalists back in June that Bulgaria plans to achieve a balanced budget in 2006. This deficit would then increase temporarily to 2% in 2007, as EU accession will initially require significant national subsidies in the agriculture sector, but then return to zero in 2008.
Instead, the biggest challenge for Bulgaria is expected to come from the inflation criterion. This states that inflation should not exceed the average inflation rate in the three euro-zone countries with the lowest inflation by more than 1.5 percentage points. Based on this rule, Fitch Ratings agency estimated back in July this year that the maximum inflation rate allowed for countries wishing to adopt the euro in 2007 would be somewhere in the region of 2.7%.
Although Bulgaria’s 2003 inflation rate of 2.3% would make the grade, inflationary pressures this year from higher oil prices have added to concerns that Bulgaria may not be able to meet such low a target in 2007. The Agency for Economic Analyses and Forecasts (AEAF) reported this week that higher oil prices will force the cabinet to change its consumer price inflation forecast for 2004, with the average annual price hike likely to be 6.8%, up from the 4% target.
Moreover, experts say that controlling inflation will be particularly difficult if Bulgaria joins ERM II at the same time as it joins the EU.
Experience in other countries shows that in the short term, EU membership produces strong inflationary pressures. Falling interest rates, an increase in investment activity and upward adjustment of harmonised excise duties all tend to lead to higher inflation.
Moreover, analysts point out that prices in some sectors, such as electricity, heating, cigarettes and fixed-line phones, have been kept artificially low in Bulgaria and will have to increase upon EU accession, thus triggering further inflation. The country will therefore need to develop specific anti-inflation policies to be able to meet the 2.7% target. The sooner the state can successfully achieve the privatisation and liberalisation of these sectors, the more able it will be able to keep a lid on inflation after 2007. Yet, with so much less in its way, Bulgaria has a real chance of gaining a double victory – entering both the EU and the euro zone in quick succession.
