With the sharp domestic economic downturn and increased investor worries over an eventual break-up of the Latvian currency peg, the sustainability of Bulgaria’s currency board arrangement (CBA) has been brought into question. A possible devaluation of the lat exchange rate vs. the euro is likely to raise the risk of competitive devaluations of other currency pegs in Central Eastern Europe (CEE), including the currency boards of Estonia, Lithuania and, to a lesser extent, the CBA of Bulgaria. A lat devaluation would tend to depress financial asset markets in Central Eastern Europe, generating conditions of panic for all nearby emerging economies.

Our analysis indicates that Bulgaria’s currency board is sustainable and would be abandoned only if policy makers believe that this is the best way to proceed for eventual euro area entry. Despite the global financial crisis, heightened regional uncertainty and lingering devaluation worries in Baltic States, Bulgaria’s CBA continues to be supported by a number of factors, which differentiate it from other currency pegs in CEE.

First, Bulgaria’s CBA enjoys strong public and constitutional support, while its technical requirements continue to be comfortably met. Second, Bulgaria’s CBA is also supported by both a large pool of foreign exchange reserves and a strong fiscal position, while the current economic recession is much milder than in the Baltic States.
Finally, Bulgaria’s banking sector is well-capitalised and has limited exposure to single-lender contagion risks, while its central bank has the flexibility to undertake ""strictly limited" lender-of-last resort operations, which can diffuse events that cause domestic financial stress.

Eurozone entry

Currently, Bulgaria has no official deadline for adopting the euro. Recent polls conducted by Reuters and other news agencies show that the market expects the country to join the euro area no earlier than in 2014. Yet, recently Bulgarian politicians make statements about expediting the process.

In March 2009, Bulgaria’s former prime minister Sergei Stanishev pressed for a swift entry in the Exchange Rate Mechanism (ERM2), viewing it as a step to cushion the effects of the global financial crisis. On March 1, in a special informal EU summit, German chancellor Angela Merkel signalled that the process of joining ERM2 could be accelerated for candidate EU states. Merkel insisted that there could be no change to the Maastricht treaty rules, but said that the EU could consider requests by several euro area candidates to enter ERM2 faster than earlier planned.

More recently, Simeon Dyankov, Bulgaria’s new Finance Minister, said that the country will apply for ERM2 entry in November 2009 and maintain its currency peg until joining the euro area.