From the CIAO Atlas Map of Europe 

email icon Email this citation


Currency Board In Bulgaria: Is It A Solution Or The Economic Consequences Of The Last Socialist Governments?

Dr. Iliana Zloch-Christy

University of Vienna
Department of Economics

International Studies Association

March 1998

Summary

The paper analyses the currency board in Bulgaria. It attempts to answer the question whether the proposed and accepted currency board arrangement is a solution to the economic problems of this country. After the introduction remarks, part one presents an overview of the hyperinflation and stabilization in some countries in the past. Part two poses the question why currency board and what are the alternatives. Part three attempts to answer the question whether it is a solution The concluding remarks summarize the findings of the paper with a sceptical view for the consequences of this economic policy.

Currency board was introduced in Bulgaria in July 1997. It was suggested by the International Monetary Fund as an alternative to address economic policy dilemmas in the country. Bulgaria experienced hyperinflation in the fall of 1996 and early 1997.

By reading the Bulgarian press and professional journals, I have the impression that the Bulgarian politicians, government officials and scholars do not realize the importance of this institution and the political, economic and social consequences in the short and medium term.

This paper attempts to answer the question whether the proposed and accepted currency board arrangement is a solution to the economic problems of this country. The structure is as follows: after the introduction remarks, part one presents an overview of the hyperinflation and stabilization in some countries in the past. Part two poses the question why currency board and what are the alternatives. Part three attempts to answer the question whether it is a solution. The concluding remarks summarize the findings of the paper.

1. Overview

The former World Bank chief economist Michael Bruno in a book published in 1993 (p.14, footnote 17) cites a statement by a collegue of him as governor of the Bank of Israel during the hyperinflationary period in Israel in the 1980s: "Has the situation deteriorated badly enough to be good for us policy advisors?"Following the statement of Michael Bruno the question arises: If the situation deteriorated so badly in Bualgaria in 1996, is it good for the policy advisors, and if yes, is currency board a solution, good enough for the country. But before answering this question, let me present a brief overview of the hyperinflation in other countries and their policy responses.

Inflation and hyperinflation are 20th century phenomena associated with printing paper money. In this century the classical cases of hyperinflation are the German, Polish, Austrian, Hungarian, as well as the post World War II inflations in Europe. The four countries that had the biggest price increase in the period 1950-1985 were the three Latin American countries Argentina, Bolivia and Brazil, and the Middle Eastern Israel. Other countries with hyperinflationary crises were Chile (1975), Mexico (1988) and the two European countries Yugoslavia (1990) and Poland (1990). All that indicates that Latin America holds the record of hyperinflation after the World War II. (Bruno, p.18).

Hyperinflation is associated with a monthly rate of price increase exceeding 50 per cent. It is a serious macroeconomic problem and usually takes place as a result of internal economic and political crisis associated with failed or inadequate response to external shocks and big domestic and external debt. All inflationary cases have common roots and namely internal imbalances: large budget deficits. The nature of the inflationary process as well as the policy adjustments have varied across countries but the economic, political and social seriousness of tackling this macroeconomic problem associated with low or negative growth, is the same for all of them. Extremely high inflation rates make it virtually impossible for the firms and households to have a clear picture of the present, and obviously of the future structure of relative prices with all the disastrous consequences for drop in production, investment activity, depletion of ressources and also destroying the human capital. All that leaves a vacuum that may take years and even decades to fill. 1

In all of the countries the hyperinflationary periods appear to have been very intense and explosive processes with high (more than three digit) annual inflation lasting no more than twenty months (Bruno, p.20). In all of the countries the end of the hyperinflationary process took place once the government signalled a credible shift of policy and in the first place sharp institutional reforms such as a credible fiscal balance and a strong central bank. All that led to very quickly and dramatical change in private sector expectations and inflationary behaviour, which put an end to the inflationary spirale. In these cases experiencing hyperinflation, the possibility of using currency board was not discussed. It might be interesting to mention here that after the World War I currency boards existed in a number of colonies effectively placing them on the gold standard. And as is well known the re-introduction of the gold standard in the developed West (UK, France, USA ) and in many other countries in that period caused recession in almost all of them.

Currency board is a financial institution replacing the existence of a Central Bank (abolished or transformed during its duration) and associated with a strictly monetary discipline where no more domestic money can be printed and put in circulation at a fixed exchange rate than the existing foreign exchange reserves. As Stanley Fischer briefly defines it "the monetary theory of the currency board is exactly that of the gold standard" and it "provides one example of a truly fixed rate regime, with the strongest of commitments to the exchange rate peg." (1996, p.37).

Currency board was introduced in the 1990s, for example, in Argentina (1991), Estonia (1992) and Lithuania (1994), with the intention not to end a monetary crisis, but rather to avoid in the future such crises. In the case of Argentina it was introduced after a painful period of protracted inflation and hyperinflation during the 1980s.

2. Why currency board?

Currency board is associated with policies aimed at achieving macroeconomic stabilization and in the case of the present developments in Bulgaria with the inflationary recession. It is introduced when other possible approaches as price, wage and money supply controls are seen as not credible. It is a very harsh institutional arrangement to stabilize the national currency since the government has no room for flexibility if policy adjustments are needed.

As alternatives to currency board two policy approaches dominate stabilization efforts: firstly, stable peg policy (fixed exchange rate) associated with considerable foreign exchange reserves, and secondly, floating exchange rate associated mainly with high domestic interest rates. These policies, of course, are monitered and directed by the Central Bank. And again to turn to a statement by Stanley Fischer in a recent article where he points to the importance of Central Bank independence: "I advocate central bank independence."(1996, p.37). He stresses also that countries with adjustable peg have had lower inflation on average during 1979-93.

The question arises: why currency board given the other two policy alternatives? The general answer is: depends on the credibility of the government and its policies. Since currency board was introduced voluntarily only in few cases, this fact suggest the short answer: depends if the governement is seen by international creditors as credible or not. All that summurizes the main reasons for currency board: lack of credibility of government policies plus lack of foreign exchange reserves and access to the international capital markets.

What was the policy of Bulgaria in combating the inflationary recession in the recent years when the country de facto was run by socialist (old communist) governments? The short answer is obviously: unsuccessful. The longer answer is that given the serious macroeconomic imbalances in Bulgaria, her governments have been tempted to increase the money supply, which enables them to increase government spending without having to rely on the highly inefficient tax-collecting system with the limited possibilities of borrowing from the public and budgetary problems on the revenue side.

As stated in my 1996 edited book on Bulgaria in a Time of Change: Economic and Political Dimensions(pp.154-156) eliminating inflation proved to be a too ambitious goal to all of the governments after 1989 given the economic collapse of the country.The ineffective monetary policies proved difficult to sustain because of populist social and political considerations which led to the vicious circle of another round of inflation and higher unemployment. The Bulgarian policy makers learned obviously little from the experience of a number of developing countries and namely the basic lessons that a failure to adjust to the constraints imposed by the balance of payments (BOP) - huge external debt - and a growing domestic debt in a situation of reduced internal productive capacity will lead to (hyper)inflation and disaster.

It is obvious that the Bulgarian policy makers do not undestand the development of crisis and have little (or none) ability to avert them. They were not able to tackle the problem to live with inflation over some time, focusing more on structural reforms (institutional reforms, de-monopolization, privatization) This is, of course, a risky approach and requires great sophistication of economic policy and abilities of the policy makers, obviously too difficult task for the present Bulgarian elites.

It might be interesting to mention here that one of the former finance ministers of Brazil said some years ago: "If inflation is a horse I know how to ride it." The Bulgarian economic policy makers did not know how to tackle this challenge and did not make any effort to work on a long term vision of reform steps encompassing areas as stabilization, privatization, industrial policy, foreign investments (among others). At present they are confronted with the need to introduce currency board since they were not able to negotiate any other polcy approach with the international creditors of the country. The care taker government of the so called democratic opposition signed an agreement with the IMF for currancy board. Even that the victory of the democratic opposition at the elections in April 1997 was expected, the international institutions insisited on the introduction of currency board. And this fact speaks for itself.

3. Is currency board a solution?

The discussion in the previous sections shows that the Bulgarian economic policy makers are obviously on a crossroad. Some of them see currency board is a kind of panacea for the troubled Bulgarian economy. Just to mention here the statement of the former advisor to the socialist governments I. Angelov that the introduction of the currency board "is the only possibility to stop the economic collapse" (Sega, No.4, 30 Jan-5 February 1997, pp.30-32, p.30). Is it really?

My answer is: I doubt it. In the following I am briefly explaining why. Currency board is in principle an exchange rate approach to combat inflation. It presupposes something which is rarely given: there must be absolutely no difference between the domestic rate of price increase and that of the country (or countries) which currency (or basket of currencies) serve (s) as the key currency/currencies. In May 1997 it was announced that the D Mark will serve as an anchor currency and this arrangement was made as of 1 July 1997 . If there is a price increase differential, and in the Bulgarian case this is unavoidable given the collapse of the economy, the consequence is something which might be called a repressed depreciation , since the exchange rate is fixed. The consequences are numerous, but I would point here the following four:

  1. The Bulgarian Lev will appreciate in real terms with the negative impact on the country's export and competitiveness.

  2. The trade balance and the current account will deteriorate.

  3. Balance of payments financing will be urgently needed, thus deteriorating further the external balance.

  4. Real incomes will decline, given the downward pressure on the value of the currency.

Currency board arrangements might put severe strains on the banking system, as Stanley Fischer stresses (1996, p.37), since there is no lender of last resort (Central Bank). This does not apply if the country has built up a large excess of cover for the domestic monetary base (like in Hong Kong, where currency board functions for many years) . This obviously is not the case in Bulgaria. It might be interesting to cite here again Fischer's statement that "currency board can "work well if fiscal policy is highly responsible and the commercial banks are international" (p.37). An intriging question arises: how many international commercial banks have licences in Bulgaria and from which countries they are? And these are major dilemmas for the Bulgarian economic policy makers, in a situation of giving up on central banking. And one more remark in this regard: as was stressed in sections 1and 2, in principle, a currency board arrangement is giving up on central banking, and is based on gold standard monetary policy rules and as its well known advocate at present, the American scholar Steve Hanke has put it "it represents a historic deviation from IMF orthodoxy" (Transition, vol.8, No.1, February 1997, p.8). He stresses further that the IMF has asserted in its programmes that central banks are lenders of last resort and the provision of credits were seen as engines for economic development. There is an urgent need to create teams of professional economists to work on strategy (and alternative strategy) of reform and economic policy.

All that indicates that it will be only a question of time (like in Lithuania) that voices for abolishing the currency board will be heard. Since it is obviously a classical deflationary arrangement with drop in production, investment and rise of unemployment, the pressure from the trade unions for its abolition will increase. Many loss-making enterprises will be forced to restructure or close, and banks that provided loans to such enterprises will be bankrupted. Decline of output and rise of unemployment are logical consequences. Ironically I do agree here with the statement of Steve Hanke that currency board " will satisfy two necessary, though not sufficient condition...to reform: stable money and monetary stability" (p.9). These conditions are not sufficient to reform because stabilization is only one step of the reform effort.

Social unrest is very probable scenario. Remember the January 1997 mass demonstrations against the socialist government. The question arises who will lead the new demonstrations in the future and against whom. These are obviously not only questions of economic policy but serious questions which require strategic long-term thinking on the part of the economic and political elites in Bulgaria. There is an urgent need to create teams of professional economists to work on strategy (and alternative strategy) of reform and economic policy in the country.

All that indicates that currency board should be seen not only as a political decision of the moment, but as a serious institutional arrangement which might make more harm than good to the country fro many years, even decade. It is an illusion to think that stabilizing unstable inflationary expectations, which, of course, can be achieved rapidly with currency board, solves the main problem, and namely eliminating stable inflationary expectations altogether. 2 There is a danger that a currency board itself might become increasingly a factor of uncertainty, thus contributing to a further destabilization of the economy. With liquidity in shorter supply, delays in privatization, almost no banking restructuring, restrictions on Central Bank lending to the government and the banks, low flows of foreign investments, barter transactions will play an important role, the net result being a massive loss of efficiency, destruction of human capital and rise of transaction costs. It might take again many years to repair the damage caused by the means that were used to combat inflation. All that indicates that it is an illusion to expect a rise in economic growth after the initial stabilization when currency board is introduced. And what matters for the future is the rise of economic growth, productivity and consequently living standards. This should be the goal of a macroeconomic stabilization: to create the grounds for economic growth and employment.

4. Concluding remarks

By combating inflation there are different mechanisms for achieving price stability. Currency board is the most harsh one and this is obviously not the most efficient one since its deflationary effects are very strong. They say politics is the art of possible. Economic policy is the art of choosing the best strategy for the country. I doubt if the Bulgarian policy makers realize this challenge. And to conclude briefly: the problem of Bulgaria is not her currency but her government. These are the economic consequences of the last socialist (communist) governments (with their cleptonomics) as well as of the deeply rooted communist culture in the Bulgarian society.

Notes and References

Note 1: It might be interesting to mention here the statement of J.M. Keynes for the danger and destructionary forces of inflation: "Lenin was certainly right. There is no subtler, no surer means of everturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which no one man in a million is able to diagnose" (1988, p.236). Back.

Note 2: According to official publications the main macroeconomic indicators deteriorated in 1997: real GDP - 8% (over the previous year), gross industrial production -11.5%, consumer price inflation 578.5 %, unemployment rate 13.5% (compared to 11.1% and 12.5% in 1995 and 1996 respectively). National Statistical Institute, Sofia, January 1998. Back.