Default setting

Bulgaria’s first option is to maintain the current peg and try to join the euro area as soon as possible. This represents our baseline scenario, as the Bulgarian economy is currently in a much better shape than the Baltic economies and its foreign currency reserves continue to provide strong coverage of its monetary base and broader monetary aggregates.

The key question therefore is not about the sustainability of the country’s currency board arrangement. It is about whether the maintenance of the present exchange rate is the best policy for ensuring sustainable medium-term growth and macroeconomic stability. The possibility of joining the euro area soon is also open to question.
The first argument in favour of such a policy path is that it can eventually lead to euro adoption with the least possible disruptions for the domestic economy and markets. Specifically, the maintenance of the present currency board arrangement would prevent a de facto lev devaluation from inflicting immense pain on domestic household and corporate balance sheets.

Second, the maintenance of the current FX regime would ensure the continuation of the successful macro stabilisation policies that have been in place since 1997 and also mitigate the risk of a disruptive spike in inflation and inflation expectations.

A major argument against the maintenance of the present currency board arrangement relates to the real effective exchange rate appreciation and the ensuing macro imbalances in recent years. If Bulgaria were to adopt the euro with a significantly overvalued currency, it would be very hard to reverse the overvaluation once a member of the euro area. The experience with countries of the European South after the formation of the euro area is not very encouraging.

Old members of the European Monetary Union (EMU) may no longer be as willing to easily accept new members, unless the latter can somehow signal their structural policies that would improve the competitiveness of their economies within EMU. Such policies take time to administer effectively and, hence, euro area entrance may delay.

The second potential cost of maintaining the present currency board arrangement relates to the hard budget constraint that it places on fiscal authorities. This effectively limits their ability to adopt a counter-cyclical policy stance that would aim to contain the effects of the global recession. In that sense, the CBA can exacerbate the domestic recession while the global crisis lasts. Yet, this might not be as bad as the worsening in domestic economic conditions that would result from a large depreciation of the domestic currency.
Overall, maintaining the currency board and joining ERM2 at today’s exchange rate is a policy that can be effectively administered and ensure timely euro area entry. Yet, it is also a policy that comes at a great long–run cost, namely a loss of competitiveness that would be harder to reverse inside the euro area.