Bulgaria (Prepared By Anton Nakov) 11Monetary Policy

bulgaria ======== (prepared by anton nakov) ========================= 1.1monetary policy in bulgaria -----------------------

Bulgaria
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(Prepared by Anton Nakov)
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1.1Monetary Policy in Bulgaria
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Within the group of emerging-market economies covered by this study, a
salient feature of the Bulgarian experience during the transition
period is a currency board arrangement, effective since mid-1997. By
that arrangement, the central bank relinquishes its power to conduct
independent monetary policy, and instead commits to a rule of
maintaining full convertibility between local currency and reserve
currency at a fixed exchange rate. In this sense, the Bulgarian
transition experience consists of two distinct episodes: prior to the
introduction of the currency board, and under the currency board
arrangement.
During the first period, from the beginning of transition until
mid-1997, the goal of monetary policy was to maintain the external
(exchange rate) and internal (price) stability of the national
currency, with a bias towards maintaining the exchange rate since
1992. To that end, the Bulgarian central bank used a variety of
instruments, ranging from the more conventional ones such as the base
interest rate and open market operations to less usual ones such as
credit ceilings, and, in some cases, even the closing of commercial
banks. Policies, however, was subject to numerous and severe
constraints, including a low level of foreign reserves, substantial
output loss, high firm indebtedness (resulting in part from soft
budget constraints on state-owned enterprises) and a high level of
non-performing loans in banks’ portfolios. An additional burden was an
unsustainable fiscal position accompanied by persistently high budget
deficits (see figures 1 - 3). Moreover, as a consequence of the
partial default on the foreign debt in 1990, the country effectively
had no access to the international financial markets.
In this environment, monetary policy was subordinated to government
priorities and covered fiscal and financial losses (directly or
indirectly) by printing money (figures 4 and 5). Commercial banks were
systematically refinanced, both in local and foreign currency, to
avoid a banking system collapse. The instruments of monetary policy
most actively used in this period included the base interest rate
(figures 6 and 7), required reserves (table 1), and, since 1993, open
market operations, including repurchase agreements and reverse sales
agreements, as well as bank refinancing. In 1995 – 1996, more than 90%
of all refinancing that took place was unsecured.
The macroeconomy during this first period was marked by rapid
depreciation of the national currency (figures 8 and 9) with quick
pass through to inflation (figures 10 and 11). Nominal interest rates
remained high throughout the period (figure 12), but real interest
rates were negative most of the time. Raising the base interest rate
proved ineffective to stop the exchange rate depreciation and curb
inflation.
Under these hyperinflationary circumstances, and after a political
crisis, the newly elected government used its mandate for reform to
introduce a currency board starting in mid-1997. The idea was to use
the straightjacket of the currency board in order to provide a nominal
anchor for inflation expectations. It should be noted that the
currency board arrangement is a stronger commitment than a
conventional fixed exchange rate regime, thus enhancing credibility.
At the same time, the currency board was deemed as an instrument for
forcing a tighter fiscal discipline upon the government.
Some of the main characteristics of the currency board arrangement in
Bulgaria include the following:
*
The exchange rate of the domestic currency is fixed to the Euro
(to DEM prior to 1999)
*
The monetary liabilities of the central bank are fully backed by
highly liquid foreign exchange reserves
*
BNB is committed to exchange unlimited amounts of national
currency against reserve currency at the fixed exchange rate
*
Law on BNB prohibits financing to the government in any form
*
Law on BNB prohibits the refinancing of commercial banks except in
the case of systemic crisis and against first rate collateral
At the same time the currency board in Bulgaria displays some
peculiarities:
*
Monetary liabilities include government accounts with the central
bank
*
Banks are obliged to maintain minimum reserve requirements with
the central bank (since the introduction of the currency board
reserve requirements have not been used as monetary policy
instrument)
*
The lender of last resort function is retained in a form not
violating the currency board principles, meaning that insolvent
bank are closed
*
BNB may extend loans to commercial banks only in the case of
liquidity risk which may affect the stability of the whole banking
system
*
Loans to commercial banks may be extended only up to the excess of
the foreign exchange reserves over the total amount of monetary
liabilities
Not surprisingly, soon after the introduction of the currency board
arrangement, and following the drastic reduction in money growth
(figures 13 and 14), nominal interest rates and inflation fell to
single digit levels1 (figures 15 and 16). Since then, domestic
interest rates have been on a path of converge to interest rates in
the Euro zone, and the low inflation environment, coupled with the
much needed structural reforms which were finally launched during this
period, fostered sustainable economic growth (figures 18 and 19).
However, it should be noted that since the introduction of the
currency board, the central bank has lost control of its primary
instrument for affecting output and prices, and banking supervision
has become the main function of BNB. Table 2 outlines the key dates in
the transition history of the Bulgarian National Bank.
1.2Research Activity at the Bulgarian National Bank
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In 1998 a dedicated Research Division was established in the Bulgarian
National Bank, with 9 people devoted exclusively to research activity.
Over the period 1998-2004, the research staff has produced some 40
discussion papers, which are available on the Internet in both English
and Bulgarian. Some of these papers are joint work with visiting
scholars under the newly started Visiting Researcher Program. The
program aims at attracting experts in the area of finance, economics
and econometrics, to do research on topics of interest for the Bank.
Most of the papers address topics, which are closely related to the
particular Bulgarian economic and financial environment, many of them
dealing with different aspects of the currency board, credit
rationing, forecasting models etc.
Apart from the discussion papers, the bank makes periodical
publications, such as a monthly bulletin, a quarterly issue on the
government securities market, a quarterly bulletin on commercial
banks, a semi-annual and an annual report.
While at present the possible impact of research on monetary policy in
Bulgaria is small, for the simple reason that the central bank follows
an automatic rule, this link is expected to strengthen in the near
future as Bulgaria switches to the ERM II regime as part of its
transition to the EMU. Under that regime, the exchange rate peg will
be abandoned in order for markets to determine the equilibrium
exchange rate of the Bulgarian Lev vis-à-vis the Euro. During that
period until joining the EMU, the central bank will have as its main
objective maintaining the exchange rate within a certain (relatively
wide) band, leaving some scope for independent monetary policy.
Figure 1

Figure 2

Figure 3

Figure 4

Figure 5

Figure 6

Figure 7

Figure 8

Figure 9

Figure 10

Figure 11

Figure 12

Figure 13

Figure 14

Figure 15

Figure 16

Figure 17

Figure 18

Table 1. Changes in Required Reserves
1991
7%
1994
8%, 9%, 10%
1995
11%, 12%
1996
9.5%, 8.5%, 10%, 11%
Table 2. Key Dates in the Transition Experience of BNB
1991
Two-tired banking system was introduced. Enacted Law on BNB, giving
BNB the status of a modern central bank with a considerable level of
autonomy
1992
Law on Banks and Credit Activity was enacted
1996-1997
Financial crisis. Fourteen banks closed. Hyperinflation during three
months
June 1997
Law on the Bulgarian National Bank (presently in force) was enacted.
Currency board introduced.
July 1997
Law on Banks (presently in force) was enacted.
References
Nenova M. 2004. “Monetary Policy in Transition: The Case of Bulgaria”,
presentation at the CPS Workshop, June, Budapest
1 The temporary peaks in inflation during this period correspond
largely to changes in administered prices and excise taxes, as well as
oil prices.