VIEWS FROM THE CAPITALS

Summer 2008

by Roumen Avramov

Bulgaria’s January 2007 membership of the EU ushered in a period of adjustment with the European institutions. The political class was eager to demonstrate its self-confidence, and one of the most publicised outcomes was Bulgaria’s decision that the official spelling of the European currency was to be evro (the Bulgarian-Cyrillic form) rather than the ECB-promoted euro.

This symbolic “breakthrough” hides the much more important issue of Bulgaria’s eventual adoption of the euro. The procedure is that before joining the eurozone a candidate country has to spend at least two years in the exchange rate mechanism (ERM II). As a country that has successfully been running a currency board since 1997, Bulgaria – along with Estonia, Latvia and Lithuania that were in a similar position – seemed well along the path to the single currency. Operating a currency board based on the euro is equivalent to surrendering monetary sovereignty to the ECB, and is therefore akin to eurozone membership in even though there remains a hypothetical risk of devaluation.

Bulgaria’s fast track membership schedule has, however, been postponed sine die. It is still outside ERM II and the ECB is clearly hostile to the move. It is a deadlock that reveals a conceptual and legal vacuum in the Maastricht treaty’s framework. Unlike the adoption of the euro, the entry into the European monetary mechanism is not subject to formal criteria, so no legal grounds exist for opposing a country’s application to join ERM II. The negotiation process is extremely opaque, and the ECB’s reluctance is tacitly based on its assessment of Bulgaria’s economic outlook. The bank is particularly concerned about the current account deficit that stood at 21% of GDP for last year, as well as by signs of credit overheating and foreign direct investment that consists of one-third real estate. The ECB perceives the situation as fragile and a threat to the stability of the currency board i.e. as a potential risk of devaluation. Bulgaria’s counter-arguments stress robust economic growth that averaged 6% over the last three years, the continuous increase of foreign reserves, and the fact that the current account deficit is covered by a steady inflow of FDI. In brief, a healthy catching up, not a consumption excess.

Sofia’s major argument is that sticking to fiscal orthodoxy over a decade, along with its ex-ante fulfillment of four of the five Maastricht criteria (except inflation) should be rewarded and not penalised. A suspicion arises that the ECB’s stance vis-à-vis the eurozone candidates is based on prejudice and perhaps on a deliberate cultural divide.

The risks associated with admitting Bulgaria into ERM II would in any case seem to have been over-stated. The officially-agreed status of currency board countries in ERM II rules out ECB intervention in support of their currencies. And if a devaluation danger really does arise, the most reasonable step would be to counter it by accelerating that country’s adoption of the euro rather than to make matters worse by keeping it out of the eurozone. On top of all this, the size of the Bulgarian economy is so comparatively small as to in no way affect the stability of the whole system.

The ECB’s attitude is seen as fostering double standards, in line with the “soft treatment” of those countries that have apparently been able to infringe the rules of the Stability and Growth Pact with impunity, and the nationalisation of private risks (Northern Rock, Bear Stearns). The problem is anyway thought in Sofia not to be a strictly Bulgarian one; the country’s banking system is almost entirely European-owned, and these banks respond to the stimuli of world markets. They have simply followed the signals being given by the loose policies of the ECB and, in the US, the Fed by channelling the unleashed liquidity to best-performing opportunities in emerging markets. Bulgaria’s current account deficit, it is said, is a textbook side- effect of this pattern. Meanwhile, the question that hangs over the situation is what the ECB’s response could be if Bulgaria were to table a formal claim to join ERM II?