Bulgarian Brink

The U.S. credit crunch from last year has escalated to a full-blown global financial meltdown, and it is absurd to expect that Bulgaria will be spared by this crisis. In the last few years Bulgaria's economy has experienced an unprecedented growth. An explosion of bank lending led to a rapid growth in consumption, which brought an increasingly widening Current Account (CA) deficit of up to 25% of GDP. These deficits were offset by Capital Account flows, thus creating dependency on foreign cash. Now, when the global crisis has caused the foreign financing to dry up, it has become clear that the CA deficit levels are not sustainable.

Bulgaria's situation is interesting also because the country operates under a currency board, meaning that it has its currency pegged to the Euro. Under the currency board conditions the government and the central bank (the Bulgarian National Bank, or BNB) do not have certain regulatory mechanisms at their disposal, such as setting target interest rates or printing more money. A country that introduces a currency board commits itself to converting its domestic currency on demand at a fixed exchange rate. To make this commitment credible the central bank holds reserves of foreign currency equal at the fixed rate of exchange to at least 100% of the domestic currency issued. The central bank can increase the money supply (print new money) only when it has coverage for that in foreign exchange (Forex or FX) reserves.

This is a disciplining measure, as the government cannot use the central bank's printing presses to fund huge deficits. The money available to the government to spend is only the fiscal reserves, which are the government's savings accumulated from prior unspent budget surpluses. A large share of the fiscal reserve account (FRA) is kept at the central bank as a government deposit, and is part of the FX reserves. Bulgaria's government has already stated that it plans to use its fiscal reserve as a buffer against the financial crisis. However, although the government can use the fiscal reserve to pump cash in and prop up the banking system if needed, the FRA is not available directly to guarantee the stability of the currency board. Indirectly though, the government can deliver much needed liquidity to the banks through placing the fiscal reserve in the commercial banks, rather than in the central bank. When distributed as credits to the firms and individuals, the fiscal reserve can indirectly find its way to pay for imported goods and services (i.e. cover the CA deficit). Along the same line is a similar argument for the forex reserves. FX reserves are indirectly available for financing the CA deficit, because one way of funding in general is to spend cash reserves, i.e. local businesses and consumers would convert their cash holdings to foreign currency to pay for imports.

In less than six weeks (from November 14th to December 23rd, 2008) the Bulgarian government managed to spend 2 billion EUR from the fiscal reserve, judging from the government's deposit at BNB. This amount represents more than a fifth of the total forex reserves at BNB and this poses a significant risk to BNB's capacity to maintain the currency peg to the euro. The larger the forex reserves at the central bank, the bigger the cushion against financial disaster in Bulgaria.

We are monitoring the situation in the country, following several macroeconomic indicators. We will publish our observation here and will update all the charts on a regular basis, as data get released from the state institutions.

1. Absolute levels of foreign exchange reserves

The backbone of the currency board in Bulgaria. The downward trend at the end of the year is typical, but we see that it continues during 2009. We also plot the absolute levels of the government's deposit in the central bank (fiscal reserve at BNB). The last data shown in the graph is from June 19th, 2009. The overall drop of the FX reserves since the beginning of 2009 is more than 9.4%, with a -0.6% drop just in the last week.

These are the only indicators, which we are able to follow weekly, according to BNB's data release schedule.

2. Absolute level of currency board reserves (CBR)

We monitor the level of the "pure" currency board reserves, as the part of the total forex reserves without the fiscal reserve deposited in BNB (CBR = FX - FRA). The peak value of 9.5 b EUR in October, as well as the most recent value, is shown. We also keep track of what part of the total forex reserves is the fiscal reserve deposited in BNB. As the government has been spending more and more of the fiscal reserve, its share of the total forex reserves dropped to 29% in the first days of the new year. In the last few weeks it looks like the fall of the currency board reserves stopped, at least for now. Updated weekly - same time as the previous graph.

3. Forex reserves / Money supply ratio

The FX reserves to money supply ratio shows how many times the foreign exchange reserves cover the money supply, thus measuring how "healthy" the currency board is. Currently BNB holds more than enough reserves to comfortably cover the most liquid money supply - M1 (mainly banknotes and coins in circulation). However, in a fractional-reserve banking system, such as the one in Bulgaria, it makes sense to check whether BNB is able to honor in full all foreign exchange liabilities - not only for the total local currency in circulation (M1), but also the money created through the multiplier of the bank loans (M2). A portion of the deposits included in M2 were originally made in foreign currency, so we chose to look only at that part of M2 which is in Bulgarian Levs (BGN). The graph shows that it was only recently when FX reserves actually rose above the M2 (BGN only) levels.

While this did not present any problems for the currency board before, when confidence among individuals and institutions was high and capital was cheap and abundant, it might be different in times of global financial crisis. As we can see, the result of the sharp decline of forex reserves caused the FX reserves coverage ratio to dive steeply to 90% in December, 2008, which means that the FX reserves do not fully cover the total M2 in BGN only. In the last few months the drop stopped and the ratio stabilized around 89%. If the worsening downward trend resumes, it will pose a serious risk for the central bank's ability to maintain the Lev-Euro fixed exchange rate.

Updated monthly - next update July 29th.

4. FX reserves / CA deficit coverage

The Forex reserves to Current Account deficit coverage represents the "cash burn ratio" in months, i.e. how many more months can the FX reserves last at the present levels of the reserves and CA deficit. It is cyclical in nature, improving in the summer because of the tourist season, and dropping during the rest of the year to an average value of 18 (a year and a half of coverage). Despite the big drop of the FX reserves during the last few months, the graph reveals that the ratio has not deteriorated, but on the contrary - it has actually improved: in January it rose sharply to more than 27 months of coverage, and in February - to 44. This is due partially to the fact that our imports cost less because of the cheaper petrol and commodities, but also because the CA deficit has decreased faster than the FX reserves have fallen - imports shrink as declining demand causes companies to scale back their activities and investment, and individuals reduce their consumption. As shown on the graph, in March the trend is reversed and the deficit grows again compared with the previous month, decreasing the coverage ratio. The large current account deficit presents one of the greatest threats to the foreign exchange reserves and the macroeconomic stability in the country, as the reserves can be drained very fast, if the adverse tendency of huge deficits persists and deteriorates further.

Updated monthly - next update July 19th.

5. Inflation-adjusted levels of M1, M2, and FX reserves

Inflation-adjusted money supply is considered one of the leading indicators believed to estimate future economic activity. As a key component of the economy it has historically turned downward before a recession and upward before an expansion, and thus is one of the most reliable indicators for the direction in which the economy is heading. The chart above used the Harmonized Consumer Priced Index with a base year 2005. M1 shows a peak in the end of 2007 / beginning of 2008. A particularly worrying trend is that both M1 and M2 start decreasing after August 2008. Especially disturbing is that M1 shows a distinctive and dangerous tendency of gradual shrinkage in the last few months. Inflation-adjusted forex reserves are given just for comparison purposes. All data is updated monthly - next update July 29th.

6. "FX reserves / Short-term external debt" ratio

Short-term debt (ST Debt) is all the obligations, which must be paid within one year. We monitor the levels of the all public and private short-term external debt of the entire country which are obligations that must be honored in foreign currency. We can see from the graph that the foreign exchange reserves coverage of the short-term external debt (FX / ST Debt ratio) has been falling over the last three years. The situation reached a critical point in December 2008, when the coverage fell to below 100%. The graph also reveals that the FX reserves have been falling even further since the beginning of 2009, worsening the coverage ratio to 90%. While most of the debt obligations are private (financial institutions, corporations and households), the steep reduction in the coverage ratio (below 100%) implies that the government and the central bank will be unable to do much in the way of guaranteeing or directly refinancing maturing private debt obligations in a time of a credit freeze and lack of external sources of financing. Maturing private debt obligations denominated in FX will further fuel demand for Euros (the currency in which most of the FX debt is denominated) and could seriously jeopardize the capacity of the central bank to maintain the currency peg against the euro. Updated monthly - next update July 29th.


1. The ABC of a currency board, Oct 30th 1997, From The Economist print edition

2. How Bulgaria is destroying its "currency board", Hanke, S. & Sekerke, M., Central Banking Journal, Vol. XIV-1, August 2003

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