Prof. Dr. Ivan Angelov
Member of the Bulgarian Academy of Sciences


Bulgaria needs a managed floating exchange rate


The currency board arrangement was introduced in Bulgaria on 1 July 1997. At the time it was indispensable. At first the Bulgarian currency – the Lev – was pegged to the German Mark at a 1:1 exchange rate, and later repegged to the Euro at the same rate as the DM.

The current purchasing powers of the Mark/Euro and the Bulgarian Lev are no longer the same as 11 years ago. A precariously large gap has accrued in the inflations of the Euro zone and Bulgaria. Since mid-1997 to the end of 2007 the Euro zone has accumulative inflation of about 20% while it has been almost 100% for Bulgaria. By now the gap between their inflation and ours amounts to over 80 percent.

One lev in Bulgaria will buy you now half the products you would have bought in July 1997. To produce one Euro worth of product for export today takes twice the amount in Levs than it did eleven years ago.

Producers of the export goods find it hard to bear the consequences of this policy. This though is not true of the Euro for inflation in the Euro zone is 4 to 5 times lower than in Bulgaria. This appreciates the Lev in a pegged exchange rate regime and contributes to the decrease of the already low export competitiveness of domestic goods[1]  .The overvaluation of the Bulgarian Lev was noted in the latest European Commission convergence report[2].

We are been told that one has to protect the stability of the Lev. I am all for a stable Lev but this cannot result merely from statements of goodwill. Long-lasting pegged exchange rate with high inflation and barely any increase of productivity of labour can hardly mean that the Lev is stable. Stability is but seeming. True stability of the national currency may come around only through high growth and export rates, high competitiveness, low inflation, rapid growth of labour productivity and a reasonably balanced current account. In such circumstances the Lev would be stable even without a pegged exchange rate.

For the past 11 years the stability of the Lev has been artificially maintained by administrative means – through an exchange rate pegged to the Euro. But this could not continue forever if it were not supported by the abovementioned economic fundamentals. These prerequisites are missing in our case. We may go on for a while to maintain the pegged exchange at the cost of substantial administrative effort but the growing current account deficit would corner us even more[3].

And then D-Day will dawn – the introduction of the Euro. In the absence of the above fundamental economic prerequisites even seeming stability of the Lev will be hard to maintain. That is when the bubble will burst. Whether we like it or not – it will be taken care of by the market.

Bulgaria is expecting the introduction of the Euro – though not before another 5 or 6 years. The intentions of the authorities for this to happen around 2010 are not realistic.

What we might have to say would be how it would be introduced – gradually or abruptly. Gradual introduction would be the preferred approach. To this end for the past several years I have been recommending abandoning the fixed exchange rate of the Lev to the Euro and transition to a managed floating rate, similarly to most CEE countries[4]. These countries have been developing better than us under floating exchange regimes; they apply their own active monetary policies and have not been exposed to threats of financial destabilisation.

Should the government and the Board of Governors (BG) of the Bulgarian National Bank (BNB) maintain the firmly fixed exchange rate until we join the Euro zone, they ought to be aware that the longer this lasts, the more difficult it would be to move from Lev to Euro. For even further „inflation pressure“ would have accrued by then in the current exchange rate of the Lev which would not have had a „breather“ through gradual devaluation and would then need to deal with an even greater threshold from Lev to Euro. This kind of policy effectively means postponing the difficult decisions for the future. However, this makes them ever more difficult. The current authorities are acting so in the fear of taking responsibility of performing this complex surgery.

If a managed floating exchange rate were to be opted, then the BG of BNB should identify the margins of that float of the Lev/Euro exchange rate. BNB should amend these margins each year or more often depending on the inflation. The floating of the current exchange rate must not exceed the margins. The Government and the BNB should severely sanction any violators in order for businesses and people to trust them in their determination and capacity to perform the delicate operation.

The amount of the amendments shall depend on the current annual inflation and the programme (time-table) for the gradual „breather“ of accumulated inflation gap over the previous years. By means of a precisely managed and non-jeopardising the country's financial stability method, the gradual devaluation of the now over-rated Lev would be achieved, as would be the latter's balanced market rate to the Euro. It is recommended that the process goes hand in hand with an ever more intensive increase in the labour productivity[5]. And so the economy would prepare for a less painful transition to the Euro in 5 or 6 years' time.

If, in accordance to the Euro zone rules, the European Central Bank demands of us two years of free „floating“ of the Lev prior to joining which intends to identify the balanced exchange rate, Bulgaria would find it easier to afford this after preparation as described and without risk of destabilisation. There would still be disruptions but they would be bearable. They would be inevitable as the inflation gap would not have been completely let out yet. However, they would be more bearable as a considerable part of the accrued inflation gap between Bulgaria and the Euro zone would have by then been overcome.

If, as an exception, we were to join without a trial period and straight away headed for a managed floating exchange rate to the Euro, there would still be disruptions but within bearable limits due to our better preparedness. The managed floating rate over a few years accompanied by a gradual devaluation of the Lev is a preparation for a „softer touch-down“ for the introduction of the Euro. It is a substitute for the demanded two-year free „floating“. Free floating under current Bulgarian conditions would be very risky undertaking.

If the current permanently pegged exchange rate policy were to continue for another few years at the expected high inflation rate, some 120-130 percentage points gap in the inflation of the Euro zone and Bulgaria would accumulate just before the introduction of the Euro. This would be inevitable with the revived inflation in the process of convergence of our average level of prices with that of the EU[6], the increase in the energy and food prices on the global markets and other factors. The gradual convergence of prices, productivity of labour, income and other indicators of the Member States is inevitable. Nobody could „forbid“ or “bypass“ these fundamental processes. Equally nobody could „ban“ the higher inflation in Bulgaria over the next years.

Convergence presumes a more rapid increase of the prices in Bulgaria compared to the average inflation in the EU. This is „healthy integrational inflation“. The impact of the accrued inflation towards the appreciation of the Lev at a permanently pegged exchange rate might be partially neutralised possibly by rapidly increasing productivity of labour. But that is not the case. The step by which we are catching up with EU productivity of labour is three times smaller than that of some CEE countries. The average annual rate of increase of the productivity of labour over 2001-2007 in Bulgaria is merely 2.3%, or 3 to 4 times lower than the average annual inflation. The substantial accrued inflation gap accompanied by low and slowly increasing productivity of labour will result in a sever shock at the time of introduction of the Euro, and will have grave economic and social consequences for Bulgaria. For the exchange rate threshold we would need to overcome from Lev to Euro would then be too high.

It would not be the Government, nor the BG of BNB to dictate the exchange rate of the Lev to the Euro at that time but the market. The government may decide that salaries, pensions and other social payments should be recalculated at exchange rate approximately 2:1 (two Levs for one Euro as is our current exchange rate). But the market could not be tricked. Neither could it be dictated to! It would probably decide otherwise: due to substantial appreciation of the Bulgarian Lev, the exchange rate for recalculating the prices of the commodities would no longer be 2:1, but 3:1 or 3,5:1 – i.e. not two but three or even three and a half Lev to a Euro, to make up for at least part of the accrued inflation gap over the years and the losses borne by the exporters. The market will be the one deciding on the balanced exchange rate. This rate would be by far closer to the economic truth than the current, administratively defined pegged exchange rate.

Producers and traders would compensate a large part of the uncompensated increase in their costs in Leva over the past 11 years due to multiple increases of salaries; prices of land, energy and fuels, row materials, components, assembling, freight, communication, construction and other services, of rent and so on under a pegged exchange rate. They would do whatever the competitive environment allows to stay on the market. This would bring them a normal profitability in Euro. And nobody would be able to reproach them for that. For it is not possible for the cost of each and every production factor to have been increasing over a period of 11 years while the price of the Lev in Euro remained the same, without having been supported by substantial increase in the productivity of labour.

If no preparation was undertaken by means of transition to a managed floating exchange rate over the years prior to the adoption of the Euro, this would cause grave distress in income and prices and have dire consequences on the economic activity and standard of living in Bulgaria. Keeping up BNB's current cowardly policy is hardly the policy Bulgaria needs. Each delay in the decision would increase the economic and social price of the transition from Lev to Euro. For our economy would not be prepared for an abrupt transition. And with time this transition would inevitably get more abrupt and painful.

It is not too late yet to adopt a managed floating rate. This way the economy would prepare for the introduction of the Euro and avoid great concussions. For the overvalued now Lev will inevitably devaluate. And that will be painful. The question is whether that should happen gradually over several years prior to the adoption of the Euro (and therefore a little less painfully), or abruptly in a single go (and more painfully) – at the time of the introduction.

What are the positive effects of the managed floating exchange rate as preparation towards the adoption of the Euro?

First. Export driven producers will be getting a larger amount equivalent in Leva. They would then be able to afford larger investment to expand and modernise production facilities, to increase the wages of their employees and achieve greater profitability. Eventually the measured devaluation of the Lev would create a more favourable economic climate for the increase of output and export, both of which our economy is desperately in need of. For currently we are exporting per capita 5 times less than Slovenia and about 4 times less than the Czech Republic or Hungary;

Second. The devaluation of the Lev will make import more expensive. The importers would be more vigilant with what and how much to import and the latter to be reduced to reasonable volumes;

Third. Expensive import would allow for the return of local small and medium size producers who had been pushed out of the market, with every positive economic and social effect as a consequence;

Fourth. The exorbitantly large deficit of the current account will start dropping;

Fifth. The economy will be better prepared for the transition to the Euro and be spared the painful economic and social concussions.

What would the negative effects be?

First. The government does not enjoy the trust of the people and the business sector. It would take time to convince them that it does indeed want and is capable of administering this delicate operation in the interest of society rather than vested corporate interests. As a result at first the exchange rate would not float but would have almost a fixed upper limit within the floating margins while expecting new devaluation. There would be restraint from investment and other economic decisions over the first few months in expectation of the government's next moves. There would be a decrease of Leva deposits in favour of Euro deposits (which has already begun), and other forms of speculative operations with Bulgarian currency prior to the introduction of the shared currency. Insecurity may continue over several months depending on the determination with which the government would act and the rate at which it would ear the trust of the people;

Second. Some imported goods would become more expensive and so would the goods produced locally with imported materials and/or components. Indeed, their price is increasing already as producers not always calculate imported materials and components for their final output at the official exchange rate (2:1) but at a rate at their discretion – 3:1 or 3,5:1, depending on the behaviour of their competitors. This would increase the level of the average annual inflation over the next years to about 8-10 per cent. At first the effect this would have on the public might be negative for they would not know that by doing this part of the accrued inflation is being „taken in“, instead of erupting at once to 60-80 percent and above in a transition to the Euro without proper preparation;

Third. There would be increased costs to the budget with the price difference of imported products, row materials, intermediate goods, products and services for the public sector. And besides, the Government will spend more in Leva for servicing external public debt and other fresh foreign borrowing of both government and corporate sectors.

Some might say that given the balance (one man's gain is another man's loss) it would be on the whole the same to Bulgaria. It is not certain that there would be a balance at macro-level. Even if it were to be there, it is not at all the same, since the agents to gain and loss are not one and the same. Exporters would gain and output and export will rapidly grow. Importers would become more cautious and import will not grow at the current rates. There would be greater caution in providing imported goods for the public sector. In the long run, production and export would grow, there will be an increase in productivity and competitiveness and the current account deficit would drop. On the whole Bulgaria would gain for it will live and work in a closer to reality world instead of the distorted looking-glass of a world at the current administrative exchange rate.

The inconveniences described above are nothing compared to the concussions we will be facing if we were to introduce the Euro without prior preparation and at the current levels of accrued inflation gaps.

Discussions over the currency board arrangement and the adoption of the Euro have been going on for a while in Bulgaria. Some economists are in favour of the gradual introduction with a managed floating exchange rate in the meantime. Other economists and the authorities lead by the BNB are committed to the permanently fixed exchange rate and the direct transition, to the Euro even without the two years of trial period. Third are for instantaneous, unilateral Eurosation. The latest option is out of question for its obvious inappropriateness. It is good that the ultimate decision will be made by the European Central Bank.

As for the Bulgarian authorities, it is time for them to take accountable action. The time for idleness is over! Those who are stubbornly sticking to the pegged exchange rate by delaying the difficult decision and shifting the responsibility for the complex operation over to a different time and different people have to take full responsibility for the consequences of their policy.


Published as an abridged version in
Central Banking, Quarterly Journal,
Volume XIX, Number 1, August 2008


[1]    The long lasting pegging of the exchange rate of the Lev is one of the reasons, albeit not the most important, for the small export and low competitiveness of our goods, and the increasing current account deficit. According to the World Economic Forum, Bulgaria ranks 79th in macroeconomic competitiveness, and 83rd in microeconomic competitiveness. It is no coincidence that of all countries in a currency board arrangement or with fixed exchange rates there are permanently high and growing deficits on the current accounts. Based on Eurostat data, the deficit of Bulgaria's current account for 2007 was 21,7% to GDP, while in Bosnia and Herzegovina it was 19,8%, in Estonia 17,3%, in Lithuania - 13,7%. In Latvia where there is no currency board but the exchange rate is permanently pegged, the deficit was 22,9%

[2]    “Bulgaria does not fulfill the exchange rate criterion”. The Commission considers that Bulgaria does not fulfill the conditions for the adoption of the euro”, European Commission, Convergence Report 2008, pp. 7 and 8.

[3]    The deficit in the current account was 5,6% of GDP in 2000, 9,3% in 2003, 14,8% in 2006, 20,7% in 2007 and expected 25-26% in 2008. According to data from the Bulgarian Central Statistical Office the current account deficit for the first 4 months of 2008 amounts to 2,43 bln Euro or 14,4% more than the same period last year.

[4]    The Czech Republic, Poland, Romania, Slovakia, Slovenia, Croatia, Albania, Moldova, Russia, Ukraine, Serbia all have a managed floating rate and Belarus - crawling peg. Fixed rates are applied only in Hungary and Latvia. Besides Bulgaria, long-term pegged exchange rates in currency board situations are applied by Estonia, Lithuania and the protectorate Bosnia & Herzegovina.

[5]    Bulgaria currently holds last position among the EU member-states. According to Eurostat GDP per capita for 2007 was 38,1% of EU-27 and labour productivity was 35,7%

[6]    Based on Eurostat data, in 2006 the level of prices in Bulgaria was 44,8% of the average for the EU – 27, with 75,3% in Slovenia, 66,5% in Estonia, 61,5% in the Czech Republic, 60% in Hungary,  57% in Romania, 69,9% in Croatia. The data for 2007 has not yet been published on the web site of the EU. The average annual HICPs inflation in Bulgaria for 2000-2007 was 6,7%, with a tendency for increase in rate: 6,1 in 2004, 6,0% in 2005, 7,4% in 2006, 8,4% in 2007 and expected at least 8 to 10% in 2008. Some Bulgarian economists expect 12-14 %=