Alternative

Bulgaria could devalue the lev and target a tight fluctuation band against the euro within ERM2. The devaluation policy would have to be accompanied by policies that improve the credibility of the new exchange rate. Hence, an entry into ERM2 with a devalued currency would likely be accompanied with the announcement by the Bulgarian authorities of a comprehensive programme of structural reforms, aiming to reduce the risk of future significant overvaluation of the local currency.
The obvious aim of such a strategy would be to reclaim the competitiveness losses inflicted by the real exchange rate appreciation in recent years and dispel speculation over a future disruptive change in the country’s policy course. The potential benefits of laying out the ground for entering the euro area with a more competitive currency are hard to ignore, not least because of the high degree of openness of the Bulgarian economy.

This option will likely lead Bulgarian authorities to a new big adventure and thus requires strong political will and full preparedness, as it departs from well known past practices. A key issue would be the nature of the post-devaluation monetary policy regime and the ensuing structure of the Bulgarian National Bank. Would that be a new currency board arrangement under a new lev-to-euro exchange rate? Or, alternatively, would it be a classic two-tier banking system with a rigid exchange rate target, such as the very narrow fluctuation band around the new central parity as presently the case in Latvia? The answer to the above question is critical for judging the post-devaluation evolution of Bulgaria’s macroeconomic variables, particularly inflation.

A second drawback relates to short-term inflation risks and the ensuing inability to satisfy the Maastricht inflation criterion for timely eurozone entry. A de facto devaluation of the lev peg to the euro could theoretically be as sizeable as 30 per cent or more, so as to offset the real exchange appreciation accumulated in recent years.

Of course, forecasting the longer-term inflation effects of a lev devaluation would be a very demanding exercise. This is because besides the appropriate magnitude of devaluation, one would also need to incorporate the likely evolution of a range of key domestic macro variables. In short, a lev devaluation could, ceteris paribus, create a short term inflation shock to the economy and higher uncertainty with regard to medium-term inflation dynamics.

Overall, should Bulgaria embark on this course, the risks are high that Bulgaria may not manage to stabilise the macroeconomy and satisfy the Maastricht criteria. But, if it finally manages to do so, then it would join EMU at a more competitive exchange rate, which would improve future growth opportunities.

The unlikely option

There is also the extreme option, under which the currency board arrangement is abandoned without a new anchor for the exchange rate or even a visible date for euro area entrance. It is very unlikely to be initiated by the Bulgarian authorities, but could be forcefully imposed by the markets in view of the overvaluation of the lev. We attach a very low probability to such a scenario, but it is still worth briefly describing it, as it forms a yardstick for clarifying the differences with the previous two options.

As the recent experience with Ukraine suggests, a forced abandonment of the present rigid exchange rate regime would likely be associated with immense domestic social and economic chaos, a situation hardly describing the present political and economic environment in Bulgaria.

Under such a scenario, it is not very hard to imagine an initial period of excessive exchange rate volatility and strong depreciation pressures on the lev as the market searches for the currency’s new equilibrium level in an environment of increased policy uncertainty and reduced prospects for a speedy ERM2 entry and euro adoption. The worsening environment deals a painful blow to the domestic economy, recessionary forces aggravate and risks of a major "financial accident" in the country rise precipitously.

This represents a disaster scenario that is not likely to occur. Our earlier analysis indicates that the currency board cannot break by market forces alone.

* Gikas A. Hardouvelis is chief economist and director of research at Eurobank EFG and professor of finance at the University of Piraeus. Platon Monokrousos, PhD, is head of financial markets research at Eurobank EFG. The full text of their report is available at eurobank.gr. Eurobank EFG is the majority shareholder in Bulgaria’s Postbank.