Currency Board and Economic Development

Sound money is one of the prerequisites for sustainable economic development. A great number of empirical studies prove that low inflation countries experience faster economic growth than high inflation countries. What is the reason for this? Sound money reduces the uncertainty about the future price development and hence it makes the choice easier. It enables individuals to realize the best allocation of resources and products. Apart from this, it allows correct comparison of prices and helps decision taking.

During high inflation periods the quantity of goods and services that can be bought with specific currency diminishes across the time. Hence, the purchasing power becomes smaller and persons that hold money balances actually become poorer. As a result from inflation, hidden income redistribution happens – from persons with fixed income to the rest.

Money soundness in Bulgaria was assured through the introduction of the currency board arrangement (CBA) in 1997. It caused considerable reduction of inflation and calmed the inflationary expectations. In practice, the monetary sources of inflation were eliminated – i.e. the opportunity for “printing” money dropped out because the issuing of Bulgarian lev is a result of higher money demand by the economic agents and does not depend on the central bank.

What are the consequences of this? The rates of inflation before 1998 were considerable and the average rate is 210%, while after that they are 7.5% on annual average. Therefore, there is a significant stabilization in the value of lev and the inflation has gradually decreased (for example, it is 4.8% for the last three years). The inflationary tax rate that is a yardstick for the inflationary tax on holding money balances has also substantially fallen. For the period before the CBA introduction it is 57.7% and it is 6.9% afterwards.

These facts are indicators only for the direct effects of the sound monetary policy but we can compare the overall economic development during the two periods.

The main indicator that characterizes this development is the gross domestic product (GDP) growth. During 1990-1997 there was an annual average growth in GDP of about minus 4.7%, which was accompanied by even more considerable drop in investment by minus 8.8% per annum. After 1997, GDP growth has been 4.4% or the difference is 9.1 percentage points. There is also a positive change in terms of investment – its average growth has been 18.2%, which is a basis for higher economic growth. It is logical that the factors like privatization, market liberalization and other market-oriented reforms influence the GDP development but the basis for all of them was the currency board.

The impact of the CBA could be searched in the fiscal sector as well because this regime imposes hard budget constraints on any economic agent. One of its main elements is the prohibition for lending to the government by the central bank as well as the restricted lender of last resort function to the commercial banks. Thus, channels for inflationary money issuance like it happened before 1997 are blocked. The budget deficit was minus 6.3% of GDP per annum – a sum that was covered by the Bulgarian National Bank (BNB). Still state-owned commercial banks granted many loans to loss generating enterprises for employment maintenance purposes and, in turn, were refinanced by the central bank. In the current situation it is almost impossible and after 1997 there is an average budget surplus. Thus the CBA is a mean for efficiency enhancement as it widens the personal responsibility and hampers the artificial maintenance of ineffective resource utilization.

Another indicator that is directly related to the budget deficit is the level of the government and guaranteed by the government debt. Here, the positive development is a result from the generally balanced budget, which suggests a decrease in this debt as well as the GDP growth. This is the explanation of the significant difference before and after 1997 of debt to GDP ratio – 168% and 65.9% respectively (during the last three years the average value is 48.3%). One should note the effect of buy-back operations of the external government debt that were made possible because of the foreign reserves accumulation, which is influenced by the currency board as well.

The bulk of foreign direct investment (FDI) indicates the perception of the country as a potential source of revenues by the external companies. Stability and predictability that are also effect of the CBA are crucial in this relation. CBA has provided full capital account liberalization that is a prerequisite for easier entry and leaving the market. In terms of FDI the difference between the periods is also large. While in the first one the annual average level of FDI is USD 233.7 million or 3 percent of GDP in the second it is USD 1253.4 million and 7.4 percent of GDP respectively.

Hence, the benefits emerging from the CBA are considerable and spread over the whole economy. Still, one should note that maintaining this regime is not an easy task.

In the current situation apprehension may arise provoked by the BNB policy towards credit growth. Recently, some measures have been taken for restriction of the credit expansion that not only have not accomplished the desired effect but also have even the opposite. According to the preliminary credits data in March there is a large growth exceeding the average levels for the last year. Thus, because of the attempts to restrict credits BNB forced the commercial banks to circumvent the regulations in order to have larger basis for granting loans. There are no reliable data yet so it cannot be said if this circumvention falls within the regulation framework or there are some kind of illegal operations. If commercial banks have really broken the rules then the bank supervision will punish them but we have to remember that the initial source of disturbances in the system is the central bank itself.

The main reason for the restriction measures is that high credit growth may lead to a bank crisis. To address the problem BNB decided to slow down the growth to rates that are acceptable according to the central bank experts and do not threaten the system. But there has been not good enough communication to the public and BNB has not explained why the current rate is too high while their rate is correct.

Another problem emerging in relation to the BNB's policy is that because of the not really successful measures it loses the credibility in its capability to maintain the stability. This credibility is built during the last eight years and it is very important for the central banks all over the world. So, the central bank actions whatever they are should be directed to keeping and expanding this credibility.

As a conclusion we can say that the currency board is one of the best things ever happened to the Bulgarian economy and this is the reason why it should be maintained until the adoption of the euro.

Table: Indicators before and after the introduction of the currency board

Source: BNB, NSI, MF, and own calculations