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Speech by Tsvetan Manchev, Ph. D., Deputy Governor of the Bulgarian National Bank, at the Congress on Central and Eastern Europe, Frankfurt, 17 November 2005 BULGARIA AND THE BULGARIAN BANKING TOWARDS THE EMU Ladies and Gentlemen, It is a great honour for me to address today such a renowned audience at the Congress on Central and Eastern Europe. First of all, I would like to thank our hosts for their kind invitation and the opportunity given. In my speech I will focus on two interrelated issues. First, I will briefly present the current economic development, the condition of the banking system, and the business opportunities arising from the macroeconomic and financial stability in Bulgaria during the accession period. Second, I will describe the key points of the national strategy for joining the EMU and the introduction of the Euro. Finally, I will outline the major challenges for Bulgaria on its way to membership in the Eurozone without derogation, as well as, the progress in the adoption of the acquis communitaire in the field of banking so as to ensure the compliance of the Bulgarian financial legislation with European laws. 1. Stable and catching up economy Eight years after the introduction of the currency board arrangement in Bulgaria, we can point out several important outcomes, among them: Macroeconomic and financial stability accompanies by a sustainable economic growth at a relatively high rate - about 6% for 2005, which is considered close to the potential GDP. The growth rate for the last 8 years - 4.5% on average – contributes to the gradual improvement in living standards; A relatively low and stable one-digit inflation for years coupled with an intensifying convergence of all interest rates on the prevailing Euro area rates, and the shrinkage in the margin between lending and deposit interest rates; The tough fiscal stance since the introduction of the currency board arrangement ensured fiscal stability and sustainability through a tight control of non-interest expenditures and the continuing process of budget consolidation. The consolidated fiscal program at the end of 2005 is expected to achieve a surplus of at least 1.5% to GDP. In 2001 the public debt decreased considerably from over 80% to GDP to the acceptable levels of less than 30% to GDP in September 2005, due also to clear debt management strategies and the aggressive exploration of market opportunities. In our pursuing the goal of the EU and the Eurozone accession, the share of the USD-denominated debt gradually declined in favour of the shares in Euro and in Bulgarian Levs; After the successful privatisation of state-owned banks, the banking system is now exclusively owned and controlled by private and foreign investors. From the end of 2003 the share of banking assets owned by foreign banks exceeded 80%. Now more than 98% of commercial banks’ total assets are privately-owned. The system is dominated by three banks (Bulbank from the Unicredit Group, UBB from the National Bank of Greece Group and DSK Bank from the OTP Group), whose combined shares of total assets reached 35.3% in September 2005. Further restructuring is underway via mergers and acquisitions, which will surely decrease the number of licensed banks (from 34 currently); Although still highly dominated by the banking sector, domestic financial markets have overcome their past isolation from the international financial markets, and long-term interest rates gradually decreased following the increased inflow of FDIs and the repeated upgrading of the country's credit rating. The increasing competition in the financial sector is visible and associated with improvements in several directions - notably a greater customer satisfaction, better corporate governance and risk management, as well as less asymmetry in information; In an environment of almost full capital liberalisation the current account deficit is well backed by FDIs, which further decreases the unemployment and increases the flexibility of the labour market. As regards the economic criteria for accession, the 2005 Monitoring Report of the European Commission comes to the conclusion that Bulgaria is a functioning market economy and the continuation of the current pace of its reforms should enable us to cope with the competitive pressure and market forces within the Union. The long-lasting financial stability and the robust economic growth in Bulgaria have been recognised by international financial institutions and credit rating agencies. Bulgaria received its first investment rating from S&P’s in June 2004, closely followed by Fitch in August. Just a few days ago the third consecutive upgrade by S&P became a fact. 2. The Strategy for the EMU membership and for the Euro adoption The considerable achievements in the reform process over the last 8 years, already mentioned, are a good basis for strengthening further the economic conditions and for setting even more ambitious goals. On April 25, 2005 Bulgaria signed its EU Accession Treaty. The accession to the European Union in a year and half will be a milestone in the modern Bulgarian history, a reward for our efforts during the transition. This is another major challenge, a challenge that the entire Bulgarian society is willing and, I am sure, is ready to face. The Bulgarian economy shows that the country has moved rapidly towards the Maastricht Criteria on nominal convergence. Bulgaria is already steadily within three of them – regarding debt, deficit, and interest rates. In addition, the strong political will to adhere to the currency board rules until Bulgaria’s full EMU membership without derogation would unconditionally guarantee the compliance with the Maastricht Criterion on exchange rate stability. The main credits for this go to the balanced combination of a strong fiscal policy and a currency board, as well as the increased implementation and enforcement of the European laws. The most important decision that a country joining the EMU with derogation should make is the time horizon within which it wishes (and is able) to join the euro area and to adopt the euro as its currency. This decision must be formulated with regard to the country’s starting position vis-а-vis the Maastricht criteria and its existing institutional framework for implementing the macroeconomic policy which largely predetermines the social benefits and costs of EMU membership timing. We feel that the existing institutional framework would reduce the social costs to a minimum if Bulgaria chooses to join the euro area immediately after the EMU derogation membership. In line with the above vision, in September 2004 the Governing Council of the Bulgarian National Bank adopted the Strategy for the Central Bank’s Development until 2009, which presents our position on joining the euro area. Regarding the changeover to the single currency, the full compliance with the Maastricht criteria will be responsibility of both the central bank and the government. Being aware of this, in November 2004 we signed an agreement which defines the policy and the commitments to be pursued during the changeover to the Euro in the Republic of Bulgaria until 2010. Recently, the new coalition that came into power after the parliamentary elections in mid-2005 firmly confirmed its commitment to the above strategy and its willingness to pursue a fiscal and economic policy consistent with the goals underlying this strategy. The strategy for Bulgaria‘s EMU membership, outlined in the above mentioned documents, is based on the following principles: Accession to the Exchange Rate Mechanism II (ERM II) immediately after Bulgaria’s official accession to the EU. Preserving the currency board arrangement until we join the euro area while maintaining the fixed exchange rate of the lev to the euro at the current level of 1.95583; Unilateral commitment on the part of the Bulgarian government and the BNB to adhere to the zero deviation of the exchange rate from the fixed level (i.e. continuing the current policy); Observing the minimum term set in the EU legislation for joining the ERM II and taking in a timely manner all necessary steps for the procedure for the euro area membership. Bulgaria considers the above path as the only relevant strategy to exit the currency board arrangement. Bulgaria‘s strategy is similar to the path to the single currency followed both by the old EU member-states (like Austria), and recently by Estonia and Lithuania – the two countries with a currency board which jointed the EU in 2004. The agreement between the BNB and the government on the country’s policy towards the EMU membership largely eliminates the uncertainty regarding the macro-economic policy, thus creating an atmosphere of predictability and easing the setting of goals by entrepreneurs and households. We are fully aware of the challenges. It is well known from the theory that under a currency board arrangement the central bank cannot directly target the inflation. Actually, the criterion whose performance will be our greatest challenge is inflation. Given the current pace at which the new member-states’ price level is converging on that of the old member-states (as a result of the so-called Ballasa-Samuelson effect), this criterion is a challenge not only for the countries having currency boards, but for all countries whose price level is below the EU average. The varying of the inflation criterion due to the definition that the inflation rate must not exceed the three EU lowest average inflation rates plus 1.5% creates uncertainty. In the case of the 25 memberstates (perhaps 27 with Bulgaria and Romania), it is very likely that three countries, the so-called "best performers", would have inflation rates close to zero due to cyclical and other country-specific reasons. This means that the inflation criterion will be very strict and will require reaching inflation rates even lower than the ECB inflation target 2%. Given the highly restrictive inflation criterion and the uncertainty about its degree, we expect that the ECB and the European Commission would show greater flexibility in evaluating the performance of this criterion. I would like once again to stress the need of a prudent fiscal policy in line with the country‘s overall strategy for successful fulfilment of the Maastricht criteria. As the changes in indirect taxes and administered prices directly affect the inflation in the country, it is necessary that their catching up adjustment should be realised before the years to be taken as a basis for assessing the performance of the Maastricht criteria, i.e. before 2008. From this perspective, the intentions announced by the government for moving forward in time the harmonisation of some excise duties is a step that will considerably assist the fulfilment of the inflation criterion as it will abolish the inflationary effect from the increased taxes in the years when the assessment will be made. The policy of administered prices for some services should also take into consideration the country’s overall strategy for the adoption of the single currency. As a measure of last resort for the fulfilment of the inflation criterion it is possible that some administrative measures may also be used, such as reducing indirect taxation in the year that will be taken as the basis for the fulfilment of that criterion (for example Greece applies a similar approach). Of course, we well understand that the rates of inflation must converge on those of the Euro area and that such convergence must be placed on a sound basis, and not only as at a single point in time when the evaluation of the performance of criteria will be made. However, every economy is under a huge number of internal and external influences, which makes the highly restrictive inflation criterion very hard to achieve, especially in the absence of an independent monetary policy. In meeting the challenge of the inflation criterion, we are going to enhance the banking environment. The recent amendments to the Law on the Bulgarian National Bank brought the Bank's legal framework very much in line with the acquis of the Economic and Monetary Union, while retaining the currency board conditions and principles. Significant progress has been made in transposing the provisions of the EU banking directives into the Bulgarian legislation without any delay whatsoever in the entry in force of these regulations. To date, the following regulations are in place: In the banking supervision area Bulgaria has achieved full (compliance with Council Directive 93/6/EEC on the capital adequacy of investment firms and credit institutions; The newly adopted Law on Funds Transfers, Electronic Payment Instruments and Payment Systems is in accord with the European legislation on domestic and cross-border transfers and on transactions by electronic payment instruments; The legal framework is in place for out-of-court settlement of payment disputes by means of a Conciliation Committee having the competence to settle disputes between an initiating institution and a client in relation to the execution of transfers, as well as between the issuers of electronic payment instruments and their authorised depository as regards the issuance and use of such instruments. Directive 94/19/ЕC on deposit-guarantee schemes is fully transposed in the regulation of the bank deposit insurance. A clear schedule for increasing the guaranteed amount paid to a single depositor for his deposits with one bank, irrespective of their number and amount, has been announced, and this amount is to reach EUR 20 000 by December 31 2006 from the present level of about EUR 12 500. With the amendments to the Law on the Measures Against Money Laundering, the Rules for the Application of the Measures Against Money Laundering Law, and the Rules of the Procedure of the Financial Intelligence Agency, the Bulgarian legislation has been brought in full compliance with the respective EU directives and the Financial Action Task Force requirements on Money Laundering. By the date of the EU membership, Bulgaria will have adopted the remaining laws and regulations in the financial field, namely: A new regime of liquidation and reorganisation of credit institutions compliant with Directive 2001/24/EC on credit institutions reorganisation; Full transposition of Directive 2002/47/EC on financial collateral and Directive 2002/87/EC on financial conglomerates; A Consumer Credit Law; Regulations on credit transfers, cross-boarder transfers, as well as, on preventing and combating crime with credit cards, which will integrate, respectively, the Interbank Convention, the European Banking Standard on Cross-boarder Transfers, the CREDEURO, and the European Banking Standard on Electronic Payment Indicator (e-PI) in the national banking arrangements. Conclusion In conclusion, I would like to assure you that the BNB will consistently pursue the targets within the context of our country's EMU integration. The Bank is strongly determined to maintain the progress so far achieved and will continue these efforts so that at the point of our country's accession to the European Union it would have reached the required preparedness for the ERM II membership. The pre-accession challenges facing us would require the strong will of the central bank, the banking and financial community and the government, and their concerted efforts to reach the strategic goal of full euro area membership.