The Role of the Currency Board in Bulgaria's Stabilization

• Author: Anne-Marie Gulde
• Position: Senior Economist in the IMF's Monetary and Exchange Affairs Department

Bulgaria's latest stabilization program, which included the introduction of a currency board, marked the end of a period of economic turmoil and near-hyperinflation. What accounts for its success?

After several failed stabilization attempts, Bulgaria introduced a currency board on July 1, 1997. Controversial and difficult to implement because of Bulgaria's serious structural problems, the currency board has been a crucial factor in the success of the country's latest stabilization program. Combining a traditional, rule-based exchange arrange-ment with legal and structural measures that addressed pressing banking sector and fiscal issues, it was well designed for the task at hand-credible but flexible enough to allow Bulgaria to tackle a systemic banking crisis.

Initial conditions

In late 1996, Bulgaria was in the midst of a banking crisis and entering a period of hyperinflation. Support for the government was declining and popular protest calling for new elections was widespread. In view of the failure of the country's earlier stabilization programs, a perception was developing that, to be credible, a renewed stabilization attempt would require a visible, rule-based system, such as a currency board. Nevertheless, the economic and financial problems confronting Bulgaria seemed insurmountable at first.

Macroeconomic and structural setting. The depth of the macroeconomic crisis was daunting. On an annual basis, inflation had soared to almost 500 percent in January 1997 and surpassed 2,000 percent in March. The causes of the rapid acceleration of inflation included liquidity injections to support the country's weakening banking system, continued central bank financing of the budget deficit, and-increasingly important-faltering confidence in the Bulgarian lev, which reduced domestic money demand. In an effort to soften the currency's depreciation-from lev 487 to lev 1,588 per US$1 in the first quarter of 1997-the central bank depleted its international reserves; remaining reserves covered less than two months of imports. At the same time, falling output and growing tax evasion caused tax revenues to plummet, from almost 40 percent of GDP (annualized) to 14.7 percent of GDP in February 1997. To finance the fiscal deficit, the government issued treasury bills with successively shorter maturities and higher interest rates. Real output, which had grown in 1994 and 1995, contracted by more than 10 percent during 1996.

Structural problems were equally severe. A banking crisis had been smoldering since at least 1995. A 1996 review found that out of 10 state banks, which accounted for more than 80 percent of banking sector assets, 9 had negative capital, and more than half of the state banks' portfolios were nonperforming. Half of the private banks, including the country's largest and best known, were also technically bankrupt. Rumors about the state of the banking sector led to several runs on banks.

A first round of bank closures in May 1996 was limited to a subset of the institutions known to be weak and was therefore not sufficient to restore confidence in the banking sector. The situation continued to deteriorate, and the Bulgarian National Bank (BNB) placed nine more banks in conservatorship in September 1996. In all, banks accounting for about one-third of Bulgaria's banking system had been shut down. The BNB announced that this second round of closings would be the last and that it would keep remaining banks open. Thus, when banking sector problems intensified, the BNB's hands were tied; it reacted by injecting liquidity through its Lombard window and repurchasing government bonds-actions that fueled inflation.

Policy discussions and constraints. There was growing awareness that a visible and credible departure from past policies would be necessary to restore any semblance of normality to the economy. In addition, stabilization would require measures to prevent financial indiscipline, reduce the government's overwhelming debt-service burden, and increase the lev's attractiveness, as well as strong official commitment to reforms and widespread public support.

In November 1996...