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Speech of Mr. Ivan Iskrov, Governor of the BNB, delivered during the official visit at the Deutsche Bundesbank, 20 December 2006 BULGARIAN ECONOMY ON THE ROAD TO EUROPEAN UNION AND ECONOMIC AND MONETARY UNION Dear Mr. President of Deutsche Bundesbank, Ladies and Gentlemen, First of all, please let me express my most sincere thanks to President Weber for this invitation and for the opportunity to speak today, a few days before Bulgaria joins the family of the European Union. Today I would like to talk about the condition of the Bulgarian economy, the development of the financial sector, and Bulgaria’s economic prospects. I know very well that my audience today is very special. Bundesbank is the central bank that has been and will be fundamental to the philosophy of price and macroeconomic stability consistently followed both in Germany and in United Europe. The strong historical connection between Germany and Bulgaria Today’s meeting is extremely important to me also because of the fact that between Germany and Bulgaria, and between our banks, there have always been very strong ties based on mutual respect and good cooperation. The relations of Bulgaria and the Bulgarian National Bank with Germany and the German banking system were established as early as 1879, immediately after the liberation of Bulgaria and the foundation of the BNB. In the period from 1879 to 1944 the BNB and the Bulgarian banking system went on strengthening their relations with Germany. The BNB signed the first two agreements on the extension of foreign loans with Deutsche Bank and Dresdner Bank in 1889 and 1893. In the early 20th century the first subsidiaries and branches of German banks were set up in Bulgaria, and they continued their operations until 1949. In the late 19th century and the early 20th century the BNB and Reichsbank had a very close cooperation. The end of the Second World War, the establishment of a pro-Soviet socialist regime in Bulgaria, and the existence of the Iron Curtain in Europe considerably constrained the economic ties between Bulgaria and Germany. The dramatic political changes in Europe after 1989, the removal of the Berlin Wall, and the subsequent EU enlargement were favourable conditions and made possible the strengthening of the good economic relations between Germany and Bulgaria. The productive interaction between the economies of Germany and Bulgaria was continued and was given new incentives by the start of the economic reforms in the early 1990s. From the very beginning of the transition Germany became the biggest trading partner of our country, reaching, in 2005, a 12.1% share of Bulgaria’s foreign trade. Over the last few years, German investments have been increasing and we expect that this process would carry on and even speed up after Bulgaria becomes a full-fledged member of the EU. Current macroeconomic policy framework In order to understand the way that the Bulgarian economy has developed since 1989 one should know the starting conditions of the Bulgarian transition. I will not go into details on the characteristics of the transition from a centrally-planned to a market economy. However, I would like to point out an important fact which largely distinguishes Bulgaria from the other Central European countries. This is the fact that the Bulgarian society could not, as quickly as the other Central European countries, reach a consensus and set its priorities. Therefore, we did not carry out prompt and effective market reforms. For various reasons (mostly the lack of political will and consensus) the restructuring was delayed and we paid a high price for this – a long period of stagnation and macroeconomic instability. In the mid 1990s our country fell into a profound political, economic and financial crisis which eroded the savings of the population and undermined the confidence in public institutions. But crises, as we know from both the Bulgarian and the German economic history, bring a new impetus which triggers large-scale economic reforms. The most important thing about Bulgaria’s economic policy after 1997 is the drastic change in the philosophy that underlies the macroeconomic governance of the country. The new culture of stability, predictability and lasting sustainability is the foundation of the economic reforms in Bulgaria. This has been the driving force behind the high economic growth, foreign investors’ confidence, and the increasing prosperity in our society. In order to overcome deep economic and political crisis, in mid 1997, Bulgaria adopted a monetary policy based on currency board arrangements. The Bulgarian Lev was pegged to the Deutsche Mark (and from 1 January 1999 to the Euro) and the BNB was banned to lend to the government and commercial banks in whatever form. There was a period of painful adjustment of economic agents – a process that is well-known to and even ongoing in some of the Euro area countries. Today, 10 years later, the currency board symbolizes stability, predictability and sustainability of Bulgaria’s economic policy. At the time when the currency board was introduced the US Dollar was the foreign currency that dominated our foreign trade. The population and the companies definitely preferred the dollar for their savings. The choice of the Deutsche Mark (the Euro respectively) as the reserve currency stemmed from the political consensus for EU accession. A country with a currency board in place is viewed as mechanically importing the monetary policy and confidence of the country, or area, to whose currency it has pegged its national monetary unit. This, of course, is true but only to some extent. Confidence can be credited, but only for a while. Ultimately, confidence must be built by a consistent and prudent policy. Therefore, giving up an autonomous monetary policy would require a fiscal policy oriented towards supporting the fixedexchange-rate regime and carrying out structural reforms that would enhance the flexibility and competitiveness of the economy. The fiscal policy systematically conducted since1997, based on a balanced budget or a budget surplus reduced the government debt to levels much lower than the criterion of the European Union. This significantly improved Bulgaria’s credit rating, decreased the sovereign spread and the cost of credit, and provided better investment opportunities. The sound macroeconomic policy and the structural policies aimed at privatization of state-owned enterprises and liberalization of markets inevitably brought about significant changes in the real economy. Since 1997 our economy has been growing at relatively high rates – 5% on average. The growth sped up in the last two years due to the microeconomic reforms and the forthcoming accession of the county to the European Union. The macroeconomic stability, privatization, and liberalization of the economy, and the high degree of predictability of the policy pursued, provided far better incentives for investing in Bulgaria. Between 1999 and 2005 the amount of FDIs on an average annual basis was 8.5 % of GDP. Only about one third of these investments came from privatization deals. These massive inflows of capital largely accelerated over the last 3 years as a result of the favourable international situation and Bulgaria’s approaching membership in the EU. As an outcome, investments began to increase faster and their share in the GDP structure went up to 33% over the first three quarters of 2006 – the highest level since the start of the economic reforms. The high levels of investments certainly increased labour productivity and, along with a moderate increase in wages and unit labour costs, helped our exports to remain competitive and the country to keep on attracting direct investments. At the same time the more intense economic activities were accompanied by stable growth rates of employment and a parallel decrease in unemployment. The higher disposable household income generated by the increased employment and wages was the initial spur to a stable growth rate of consumption in the economy. Subsequently, this effect was reinforced by the rapid development of the banking sector and the improved access of households to lending. The easier access to the credit market, coupled with decreasing interest rates due to Bulgaria’s better credit rating and the global excess liquidity over the last 3 years, led to reduced 2 household savings and increased consumption. The lower levels of savings by households and companies resulting from the increased consumption and investment inevitably gave rise to a deficit on the BoP current account. Challenges facing the policy-makers As a result the current account deficit increased, reaching levels of more than 5% from the GDP in 2003 and 2004, and increased even further to 11.3% at the end of 2005. It is expected to reach 13.9% of the GDP in 2006. Current account deficits have a high level of inertia, which presupposes that the shrinking of the external imbalance of the country will be a gradual process. In addition, the economy of Bulgaria is in its initial stage of convergence, suggesting an accelerated investment growth and inflow of capital for a longer period of time. As I have already mentioned, during the last few years the country received a substantial inflow of capital and the banking system was the natural intermediary in its effective distribution. This does not come as a surprise, having in mind the successful privatization and restructuring of the banking sector in Bulgaria. At present, 99.7% of the banking sector is private, and nearly 85% of the banks in the country are owned by foreign investors – most of them from Euro area member states. Due to the strong competition and good investment opportunities the growth of the private sector lending reached levels as high as 48.6% at the end of 2004. Only for a few years the ratio between the banking credit to the GDP increased from 12.1% in 1999 to 46.0% at the end of September 2006. To minimize inherent risks from the beginning of 2004, the BNB started a process of gradual implementation of measures (mainly supervisory and administrative) which aimed at diminishing the growth rates of banking credits, down to stable levels, which do not jeopardise the stability of the economy. The data indicate a slower growth of banking credit - 23.4% as of September 2006. We do not envisage a considerable and fast credit growth in 2007. The debt burden accumulated during the last few years, as well as the monetary policy tightening in the Euro area will curb credit to a great extent. The Prospects of the Bulgarian Economy By signing the Accession Treaty with the EU, Bulgaria has committed itself to join the Euro area and to adopt the single currency. The current EU legislation does not give member states the right of an opt-out clause for their membership in the EMU. This means that the decision which our country will need to make is not whether to join the EMU and to introduce the single currency, but how it is going to be done and in what time period. Regarding the introduction of the single currency, Bulgaria and in particular the BNB, have always had a consistent, long-term policy. This policy is determined by the existing currency board arrangements and their broad national and political support. Having in mind the governing principles of the state policy and the requirements of the acquis communautaire in 2004 the government and the BNB signed an agreement, aiming at the only logical decision - to introduce the Euro in Bulgaria in the shortest possible time horizon, conditional on fulfilment of the Maastricht criteria. The document outlines the following basic principles of EMU membership: Joining the Exchange Rate Mechanism II (ERM II) as soon as possible after Bulgaria’s official accession to the EU. Keeping the currency board until Bulgaria joins the Euro area, with the current exchange rate of the Bulgarian Lev to the Euro - 1.95583 for Euro. A unilateral commitment of the Bulgarian government and the BNB to maintain a zero fluctuation of the exchange rate from the fixed level. Meeting the minimum period set in the EU legislation for participation in the ERM II and taking in time all the necessary steps of the procedure for membership in the Euro zone. The time horizon for meeting the Maastricht criteria is determined by the state of fiscal preparedness and inflation convergence. Very often nominal and real convergence processes are 3 wrongly perceived as two mutually exclusive goals. We believe that the competent combination of fiscal, structural and regulatory policies that would encourage competition on a microeconomic level can bring about a quicker real convergence while simultaneously achieving the nominal criteria. The aspiration for Euro area membership has dimensions that go far beyond the domestic economic and political aspects. From an economic perspective the adoption of the single currency is in itself the ultimate stage of the European economic integration. All national governments in their pursuit of multiple political and economic goals are often faced with contradictory objectives. Sometimes populist and short-term goals seem to supersede the main long-term ones. Therefore, the states that manage to follow a sound macroeconomic policy favouring Euro adoption set a positive example to those member states whose policy deviates from stability and long-term sustainability objectives. The political will in itself is not sufficient, but extremely necessary precondition for Euro adoption. I highly appreciate the fact that Germany has laid down in its programme for EU presidency next year that it will support the member states in their aspiration for Euro area membership. Moreover, each country will obtain a prompt and detailed assessment regarding ERM II membership and Euro adoption. I believe that this is the only prudent approach that guarantees equal treatment to all member states. All member states – both present and prospective – are responsible for the sustainability of the EMU. This sustainability favours their own interests. Bulgaria is now ready to contribute to this global aim. In the past 5 years we have fulfilled all Maastricht criteria, except for the one on inflation. We envisage to maintain this consistency in the years to come. Our efforts will be directed at curbing inflation to the compliant level. Today Bulgaria already meets 4 out of 5 Maastricht criteria and we believe that our strategy for ERM II participation as soon as possible we be fully supported by the German presidency. Our state of preparedness could be assessed by the fact that even though no preconditions for ERM II entry are required, Bulgaria has committed to proving its capacity by sustainably meeting 4 out of 5 Maastricht criteria. This provides us with the confidence that we will be a full- fledged member of the EMU at the beginning of next decade. Following the current policy of balanced budget, with a surplus if possible, will enable us to continue meeting the Maastricht criteria in terms of budget deficit, government debt and long-term interest rates, and will also make the macroeconomic policy more responsive and flexible. It is well known that under a currency board arrangements, the fiscal policy is the only tool available for a relatively quick response to adverse developments in the economy of the country. Furthermore, in order for us to have this flexibility with the growing current account deficit and rapidly increasing private debt, in periods like this when the economy is growing at rates close to or a little above the long-term growth rates, the budget needs to compensate by generating a sufficient surplus. The tough fiscal policy is needed also because it will help us comply with the inflation criterion. Operating under a currency board arrangements, the central bank has no direct control of inflation rates in the country. Given the current trend of price levels in the new member-states converging to the levels in the old member-states (a result of the well-known Balassa-Samuelson effect), this criterion is a challenge not just for the countries with a currency board in place, but also for all countries with price levels lower than the average in the EU. In the particular case of Bulgaria where a fixed exchange rate regime is in place together with a very conservative fiscal policy, reserves should be looked for in promoting the competition and improving the business environment so that the economy would have greater flexibility to respond to both external and internal challenges. In 2006, we expect an average inflation rate of 7.2 %. The main factors driving inflation at the present moment are the increase of excise duties on alcoholic beverages and tobacco. In 2007, we foresee the declining trend from the second half of 2006 to continue and our forecast is that inflation will be approximately 3.7%. Finally, I would like to express my highest appreciation of and gratitude for the steady and consistent support given by Germany and the people of Germany for the reforms in Bulgaria and 4 especially for our accession to the EU. This support is very well known in the Bulgarian society. We do hope that this friendship and assistance will continue during Bulgaria’s accession to the Euro zone and afterwards. Thank you for your attention. 5