With low interest rates, Bulgarian currency peg becomes a handicap

SOFIA – Bulgaria’s currency peg may have helped to save its economy from collapse in the last decade, but what was a crutch has turned into a handicap. With its lev chained to the euro, the Balkan state must march in step with monetary policy designed for some of the European Union’s wealthiest economies, such as Germany and France, not the bloc’s poorest member. Bulgaria’s economy is booming. But the currency board’s need to keep interest rates close to the eurozone’s has fueled soaring levels of consumer credit and a huge current account gap. Add to that double-digit wage increases and record commodity prices, and the result is a spike in inflation that the central bank has no tools to combat and is a stumbling block to Sofia’s aim of adopting the euro in 2010 or 2011. «Technically, the earliest possible date could be 2012. But it looks like it’s taking us more toward 2014 and beyond,» said Agata Urbanska, an economist at ING bank. Bulgaria’s problems reflect those of the Baltics states. They also peg their currencies to the euro under regimes that helped them to escape the hyperinflation which struck other ex-Soviet states and to survive emerging market meltdown. They, too, are witnessing double-digit price growth, which has walloped consumers by eroding their incomes and ripped the wings off of once-soaring economies such as Estonia’s, where annual growth fell from 11.2 percent in 2006 to just 0.4 percent in the first quarter of this year. Speculation surged toward the end of last year that the Baltics could devalue their currencies and raised questions about the stability of Bulgaria’s currency regime, introduced in 1997 after a financial crisis wiped out one-third of its banks. But analysts say the best solution for Bulgaria would be to crack down on fiscal policy and make economic reforms rather than abandoning or devaluing the peg. «Now there appears to be a widespread expectation that the currency board will hold up,» said Ivailo Vesselinov, EMEA economist at Dresdner Kleinwort. Political toll «A forced depreciation would certainly have a positive impact on growth in the long term but in the short term it would be a very painful experience. And that is almost guaranteed to cost very dearly to any politician who dares to implement it,» Vesselinov said. The value of the national currency touches a raw nerve in the country of 7.7 million people, where wages average -230 a month. Devaluation from the lev’s fixed rate of 1.95583 per euro is anathema a year before general elections. «The EU has only brought us high inflation, nothing else. It would be outrageous if someone now decided that a euro costs 4 instead of 2 levs,» said marketing manager Ivan Borisov. To quash fears, the government has repeatedly confirmed its intention to keep the peg until Bulgaria joins the eurozone. But just like in the Baltics, questions remain about how Bulgaria will bring inflation down and avoid an economic hard landing in the face of the global credit crunch. Inflation hit an annual 14.6 percent in April and is not likely to moderate much for some time, as GDP per capita is just 39 percent of the EU average and price levels are significantly lower than in the euro area. A credit boom also saw loans grow by over 60 percent last year and shows no signs of easing. Last week, the Bulgarian arm of UniCredit Group launched a quick leasing scheme for yachts due to increased demand, and even poorer Bulgarians are splashing out on flat screen TVs, cars and flats after decades of communist austerity. But inflation is not the only speed bump on the road to the euro. Both the International Monetary Fund (IMF) and the European Central Bank (ECB) are concerned about Bulgaria’s current account deficit. It reached 21.5 percent of GDP last year from 2.4 percent in 2002 and is likely to exceed 22 percent this year. «Although high external deficits can be partly driven by the catching-up process of an economy such as Bulgaria’s, deficits of this magnitude raise sustainability issues,» the ECB said in a report. The external deficit is not officially among the criteria for adopting the euro but it has frustrated Sofia’s efforts to join ERM-2 exchange rate mechanism, a currency stability test for euro hopefuls, since last year. Risks have also risen from a whopping gross foreign debt of 94.6 percent of GDP due to surging private borrowing. There are worries that foreign direct investment, which covers the external deficit, will slow due to the global financial woes. Some analysts suggest Bulgaria might have to tighten its fiscal belt further and raise its annual budget surplus target of 3 percent of GDP. «As long as wages are kept under control, there is no reason why, in a few years when the Bulgarian economy slows down, they should not meet the eurozone criteria,» said Daniel Gros of the Brussels-based Center for European Policy Studies.