Exchange Rate Regimes in Bulgaria - Case Study Example

Exchange rate regimes in Bulgaria – overview and impact on the economy Exchange rate regimes in Bulgaria – overview and impact on the economy Writers Name Institution Name 1. INTRODUCTION Bulgaria is considered to be a small country with a lot of potential for the new firms to enter and attain long-term growth, along with growing and somewhat stable economy. The country is located in Balkan area which is considered to be unstable location for not only Bulgaria but many other countries and make the country prone to some risk for investments and trade. Bulgaria’s income level is the lowest among the countries that have faced the transition process. In order to stop its hyperinflation and deteriorating economy Bulgaria adopted Currency Board system which speaks for a fixed exchange rate system. (Calvo and Reihnart, 2002) Most of the enterprises were state owned and were not run in a proper manner and every aspect of them was outdated and unproductive for the Bulgarian economy to perform well. In order to maintain the competitiveness and to alleviate the financial burden of these firms on state budget, the government imposes that the monetary authorities apply a soft budget constraint to the economy. This policy results in a high and chronicle inflation, and rapid depreciation of the Lev until the fatal crisis of 1996-1997. The severe crisis that Bulgarian economy was facing resulted in the failure of the first step towards the transition process which focused on moving the economy from centrally planned system towards more of a market economy. Hence this failure in the first stage of the transition process ended Bulgaria with delayed reforms and effective privatization process which became very slow and difficult because the planning was not done properly and even the implementation of the programme resulted in situations that went out of control for the country to handle. This delay in the reforms and failure in the first stage of the transition process further deteriorated the position of the government as well as the central bank in the eyes of the public as well as local and foreign investors. Initial conditions of which two most important and strong ones, which adversely affected the privatization process in Bulgaria were the bureaucracy of the government and the instability in the business environment. (Bitzenis 2003) The case of Rover Company is a major example. During November 1994, the Rover Company purchased a manufacturing concern in Bulgaria, by investing $1.4 million. Subsequently they withdrew their investment because of the problems they encountered with the government bureaucracy and the misinterpretation of the certain clauses in the agreement already signed with the Government of Bulgaria. (Marinov and Marinova 1997) The companies privatized were priced and offered to investors at a price, which they could not consider as an opportunity. (Rayome and Stocker 1995) The whole privatization process actually speeded up after the introduction of the currency board during mid-1997. This process further accelerated during 1998-1999. During this period Bulgaria encountered reasonable inflation rates and steady exchange rates. According to Bitzenis initially analysts considered Bulgaria taking a “big bang” change. The eleven years study of the changes in Bulgaria depicted a different picture. The only sign portraying the “big bang” was the freeing from price control of over 70% of the general items. However there was a long delay in the freeing of the balance items from price controls and in the enactment of the bankruptcy laws. Also state monopolies were being preserved, bad loans were increasing and the government’s inability to control inflation before the set-up of the currency board resulted in fortification of the nomenclature, increasingly disorganized privatization and consequently slow advancement in the privatization and restructuring progression. (Bitzenis, 2002) Overall the situation in Bulgaria depicted that its government tried to encourage the reorganization before privatization, persisted in funding of state companies and wrote-off some of the old outstanding amounts. This resulted in increase of bad debts and loans problems. As Bulgaria was increasingly borrowing in foreign currency, the national currency continued to lose its value resulting in the amassing of the debt. This debt the state took was not covered by the supposedly higher price of the privatization, also during the years of reorganization the country suffered great economic volatility and did not have the funds to finance its shortfalls. As such the deferment of the privatization process in hope of a higher return showed that it was a delusion. (Bitzenis, 2003) During the evolution period the legal system in the country was unsteady. The numerous changes in the substance of the laws of Bulgaria were a source of great anxiety for foreign investors as well as for locals. The drastic changes in the laws are shown by the several names; these laws have been taken on during the period spread over several years. Eventually these laws and others, which followed, created the official structure, which allowed foreign investment as per established international principles and provided an even more attractive guideline. (Bitzenis, 2006, p.91) Bitzens also writes that due to “unfavorable early conditions, a sluggish changeover procedure, and political and macroeconomic unsteadiness, Bulgaria lost its chance to obtain a larger amount of FDI flows during the period 1992 to 1996 (Bitzenis, 2006, p.99) Upto end of 1996, the levels of investment interest in Bulgaria was inconsequential as compared to other central European countries. The process of privatization was in its infancy, no prominent privatizations by FDI had been undertaken and part of the FDI flows was of an unlawful origin during this period. (Labrianidis, 1996) The delays in the reform process deprived the country of the likelihood of attracting FDI and the sway of FDI on economic life was insignificant in all esteem. From 1997 to 2000, the procedure of monetary reorganization got underway. Even after the difficulties facing the reorganization, the opening of the economy and the enormous privatization program attracted huge investment. During this period the inflows of the FDI increased substantially, accounting for an average of $770m per annum, that is more than five times higher, as compared to the first period. In spite of the increase in FDI flows in this period, FDI per capita in Bulgaria was still very low as compared to figures for other central European countries in the evolution process. The contribution of FDI to the structural changes in the economy remained irrelevant. There is substantiation that in the last few years that is from 2001 to 2004, of an inclination towards the stabilization of the industrialized growth. This procedure can be linked to the substantial enhancement of the wide-ranging economic policies in Bulgaria after 2000. The macro-economic structure has stabilized and the huge privatization of long-term assets and the reinstatement of agricultural and forestlands have both been completed. In spite of the possibility of the collapse of investment in the privatization process, total FDI flows increased to more than $1bn per annum on an average. As such in this last phase, it can be said that FDI have started to play a significant role in the structural changes of the economy of Bulgaria. 2. EXCHANGE RATE REGIME IN BULGARIA After going through severe financial crisis from 1990-1997, Bulgaria implemented a Currency Board system so that monetary stabilization could be achieved. The currency board considerably hardens the budgetary constraint and leads to real appreciation. Seven years later in spite of a sharp real appreciation, the competitiveness of Bulgaria is always high due to an important increase in productivity. Before I move on it is important to explain the concept behind the implementation of Currency Board. Currency Board is basically a financial institution which in brief replaces the Central Bank of a country and implements a 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. The implementation of Currency Board in Bulgaria brought about these changes: Firstly, the nominal exchange rate is fixed by law that is that the nominal exchange rate is fixed to 1 Lev for 1 Deutsch Mark (that corresponds to approximately 2 Leva for 1 euro). Secondly, the central bank should only accept external assets as counterpart of the base money supply. In facts, the central bank applies a principle of base money coverage by exchange reserve of at least 100%. Exchange rate reserves accumulated in excess of 100% coverage could be used in order to restore some margin for independent monetary policy Policymakers are held responsible for their actions through citizens’ ability to freely exchange the national for the reserve currency. Clear and transparent mechanisms for the central bank to perform the function of lender of last resort while making its abuse practically impossible. The implementation of some better alternative was needed in Bulgaria to force it out of the severe financial crisis it was going through. After the execution of Currency Board in 1997, Bulgaria achieved the lowest and stable inflation rate along with the highest and stable economic growth. Graph 1 Real GDP growth and inflation Annual percentage changes One of the most important arguments that were raised, was against the fixed exchange rate system and the risk that is posed due to the independent monetary policy in the country and as Hristov and Zaimov writes “flexibility in macroeconomic policy, limit the possibility of using flexible instruments to cope with external shocks. The effectiveness of discretionary policies in softening external shocks is highly questionable.” (Hristov and Zaimov, 2000) The irreversible fixing of the lev to the euro creates economic conditions identical to those that would prevail if Bulgaria were a member of the euro area. This in turn means that inflation differentials between Bulgaria and the euro area have the same effect on the Bulgarian economy as do differentials between individual member states and overall euro area inflation. The volume of Bulgaria’s international reserves (those of the central bank and those of the banking system) has shown stable growth since the introduction of the currency board, reaching unprecedented levels for the Bulgarian economy in Graph 2. This often poses the question of whether this is the most effective way of using our resources. International reserves secure four major functions whose benefits for the economy are greater than the lost opportunities to invest in domestic assets Under the existing currency board regime, foreign currency reserves are the nominal anchor determining the supply of bank reserves, banknotes and coins. Excess reserves over and above BNB’s monetary obligations, including the fiscal reserve, may be viewed as buffers absorbing both external and domestic economic shocks. In this sense international reserves can act as a stabilizer. Foreign assets are a source of liquidity in foreign currencies, which enable routine government and economic agent transactions. Graph 2 International reserves In billions of leva According to Marie Gulde “Under the currency board, Bulgaria reduced annual inflation to 13 percent by mid-1998 and to 1 percent by the end of 1998 while rebuilding foreign exchange reserves from less than $800 million to more than $3 billion—more than six months of imports.” (Marie Gulde, 1999) 3. EXCHANGE RATE REGIME AND THE IMPACT ON THE CRISIS FACED BY BULGARIA BEFORE ITS IMPLEMENTATION There is a lot that has happened after the exchange rate regime in Bulgaria. Firstly one of the most important arguments that were raised, was against the fixed exchange rate system and the risk that is posed due to the independent monetary policy in the country and as Hristov and Zaimov writes “flexibility in macroeconomic policy, limit the possibility of using flexible instruments to cope with external shocks. The effectiveness of discretionary policies in softening external shocks is highly questionable.” (Hristov and Zaimov, 2000) When the central bank collapsed and the currency board was launched, investors both local and foreign had lost all their confidence on the government and its policies and it was important to attempt any monetary policy that could have provided a better alternative to the current policies and aids in stabilizing the economy or lowers down inflation but the limited number of these alternatives available in 1997 speaks for themselves in the form of inflation, currency substitution and growth till 1997 as mentioned above that Bulgaria faced hyperinflation at this time and according to Bitzenis the unstable Bulgarian legal framework was the most serious barrier to establishing an FDI project in Bulgaria. (Bitzenis, 2006) When we talk about FDI, after the implementation of exchange rate regime, economic restructuring started taking place in Bulgaria. Even though the country faced many problems during this time period but privatization programme attracted many investments. One of the most prominent foreign direct investments came from Greek companies. According to Bitzenis in his article published in Eastern European Economics Journal explained that “Greece and Bulgaria have had trade relationships for centuries, mainly on account of their geographic proximity, their cultural closeness, similar Balkan business mentality, and common religious beliefs.” (Bitzenis, 2006) Foreign direct investments increased drastically from 1997 to 2000 for yearly average of $770m, more than five times higher compared to the first period but still this was considered to be lower than other that in other central European countries in transition and the major reason for that was certain barriers that were identified by Bitzenis in research. As Bitzenis notes that other than unstable legal environment, bureaucracy was a significant barrier to FDI in Bulgaria which made it difficult task to cope even for experienced entrepreneurs. Corruption and crime, high investment risk, limited purchase power, lack of infrastructure and macroeconomic instability contributed as barriers toward foreign direct investment in Bulgaria. (Bitzenis, 2006) According to a report presented by Stammer “After narrowing to 5.8% of GDP in 2004, the current account deficit widened sharply again to a concerning 12% in 2005, as strong domestic demand and high oil prices led to sharp rises in imports. Critically, FDI inflows declined in 2005 and are set to fall further as a result of slow progress on privatization. The debt service ratio in 2005 was pushed up to 31% by the early retirement of much of the public external debt, but is expected to decline to an acceptable level of 18% or so this year. FX reserves are also insufficient to cover fully external debt payments falling due in 2006. Summarizing, external liquidity risk has risen to some extent during the past 12 months, but the risk of an economic or financial crisis in Bulgaria is limited over the forecast period.” (Stammer, 2006) Crisis of inflation that Bulgaria was facing before the implementation of Currency Board also started to resolve as it reduced its annual inflation to 13 percent by mid-1998 from 40 percent and to 1 percent by the end of 1998 and also increasing its foreign exchange reserves from $800 million to $3billion. As Gulde mentions “BNB basic interest rate, which had been above 200 percent at the height of Bulgaria’s economic crisis, fell to 5.2 percent by the end of 1998. Retail interest rates moved close to German levels as soon as the currency board was introduced. Since inception of the currency board, no bank has had to be supported through the banking department.” (Gulde, 1999) 4. FINANCIAL MARKETS AND INSTITUTIONS IN BULGARIA While I researched and read all the data available I realised that there are some mixed concerns available when we consider the impact of Currency Board on the financial market and institutions on Bulgaria. Even though the financial institutions and markets have performed well under the Currency Board but still there are many pitfalls of the fixed exchange rate system that have been identified. For example details from the Bulgarian National Bank as published by Valev and Carlson show that “About 60 percent of deposits in the banking system are in foreign currencies. During the 2000 to 2003 period, the average spread between interest rates on one-year local-currency bank deposits and euro deposits was 284 basis points. Consistent with the currency risk premium on bank deposits, a sequence of four national surveys from 2000 to 2003 show that a non-negligible part of the population really thinks that this Currency Board will actually collapse with devaluation in the future.” (Valev and Carlson, 2004) According to Gulde “Because of the problems facing Bulgaria's financial sector, a separate banking department was established, and the currency board has "excess coverage"—that is, more foreign exchange than needed to cover the central bank's monetary liabilities. The banking department deposits these supplemental funds, which can be used to make collateralized loans to commercial banks in the event of an acute liquidity crisis, in the issue department. The banking department also holds all other assets and claims on the central bank, including outstanding long-term loans to the government and long-term deposits by commercial banks, and acts as the fiscal agent for Bulgaria's relations with the IMF. Banking department claims and liabilities other than those related to IMF drawings, lending to commercial banks, and changes related to the deposit of central bank profits will not be added to during the operation of the currency board.” (Gulde, 1999) When we consider the overall performance of the institutions, lot has been done to improve the efficiency of the banking sector and the banking system is considered to be stabilized till now. 98% of the total assets of commercial banks are held privately now and more than 75% are foreign-owned. Even the bad loan condition has improved and the bank loads to the businesses as well as to the consumer sector have increased to 26% of GDP in 2003 and the consumer deposit rate has also doubled to 40% of GDP in 2003. Due to the severe financial crisis stock exchange closed in Bulgaria but reopened in October 1997. Even though it’s been almost 10 years it has been reopened but still the turnover and capital movement is slow in the equity market but the market capitalisation of the companies increased from 5.8% of GDP in 1999 to 7.9% in 2003. Total turnover at the Bulgarian stock exchange relative to market capitalisation at the end of 2003 was 12.5%. Foreign companies are finding it attractive to invest in Bulgaria to take hold of the first mover advantage and to built in new markets and to capture the increasing needs of the customers and hence to make more profits, which brings them with an opportunity for long-term progress and growth and deep penetration and high market share into the market. The conditions for FDI penetration in Bulgaria, together with the expected accession to the EU, are attracting firms from non-EU countries to establish business activity in the country. For example, Russian firms seeking the development of economic relations with EU countries are executing these plans by entering Bulgarian markets as a country in the process of accession to the EU. 5. COUNTRY RISK ANALYSIS One of the most important issues with the Bulgaria is its location and the lack of urban centres around it which can and has created certain economic difficulties for the nation and has also become a barrier in attracting FDI for the country. This is creating a combination of certain factors that aids to the low economic activity in Bulgaria such as weak infrastructure, increasing unemployment rate, weak tertiary sector, mono-structural industrial development, low enterprise efficiency; a narrow market, negative internal migration and an ageing population and the low density of foreign firms. One of the main risks associated with Bulgaria is that Bulgaria is located in Balkan area where there is instability in the region as a whole which has a very strong impact on FDI because the investors than hesitate to invest in the Bulgaria as well as in other nearby countries as they consider it very risky for the investment and trade. For example, export insurance is very high; investment also requires significant insurance funds. Another risk associated with Bulgaria which is considered a hindrance for the foreign companies is the increase in bureaucratic system, corruption, lack of security typical of the region, unwillingness of some state authorities to do their job and the slow implementation of the decisions of the administration. The continuing changes to regulations and the laws also hamper the possibility of doing successful business in Bulgaria. Some foreign companies also claim that Bulgarians are avoiding taxes illegally which promotes disadvantageous competition and creates more problems for them to operate. 6. CONCLUSION Bulgaria implemented the Currency Board system in 1997 which speaks for a fixed nominal exchange rate regime for the country which is can have an impact of real appreciation for Bulgaria that can have a harmful impact and enhance the risk factor for the company. Bulgaria adopted a currency board in 1997. However, the currency board also brings a favorable environment for productive reforms because of the budgetary constraint hardening. From 1997 to 2000, the procedure of monetary reorganization got underway. Even after the difficulties facing the reorganization, the opening of the economy and the enormous privatization program attracted huge investment. The macro-economic structure has stabilized and the huge privatization of long-term assets and the reinstatement of agricultural and forestlands have both been completed. When we talk about FDI, after the implementation of exchange rate regime, economic restructuring started taking place in Bulgaria. Even though the country faced many problems during this time period but privatization programme attracted many investments. One of the most prominent foreign direct investments came from Greek companies but still this was considered to be lower than the other central European countries in transition. As Bitzenis notes that other than unstable legal environment, bureaucracy was a significant barrier to FDI in Bulgaria which made it difficult task to cope even for experienced entrepreneurs. Corruption and crime, high investment risk, limited purchase power, lack of infrastructure and macroeconomic instability contributed as barriers toward foreign direct investment in Bulgaria. (Bitzenis, 2006) When we consider the overall performance of the institutions, lot has been done to improve the efficiency of the banking sector and the banking system is considered to be stabilized till now. 98% of the total assets of commercial banks are held privately now and more than 75% are foreign-owned. Even the bad loan condition has improved and the bank loads to the businesses as well as to the consumer sector have increased to 26% of GDP in 2003 and the consumer deposit rate has also doubled to 40% of GDP in 2003. APPENDIX Graph 1 Real GDP growth and inflation Annual percentage changes Graph 2 International reserves In billions of leva Read More