Concerning the Bulgaran candidacy for the ERM II

1 Background
1.1 “The ERM (European Exchange Rate Mechanism) is based on the concept of fixed currency exchange rate margins, but with exchange rates variable within those margins. This is also known as a semi-pegged system....A currency in ERM II is allowed to float within a range of ±15% with respect to a central rate against the euro”(Please find more information at http://en.wikipedia.org/wiki/European_Exchange_Rate_Mechanism )
1.2 Bulgaria's economy is driven mostly by services (64.9% of the GDP1). The population is old with medium age of 42 and the small workforce of 4.6 million provides for the 7 million inhabitance. The total value of the GDP is relatively low – Euro 34 billion2
1.3 After the 2009 elections the new (incumbent) government expressed its strong desire to join the Euro-area as guarantee for fiscal and financial stability3. This is the number one priority of the economic policy and ERM II is popularly perceived as the “Euro-zone waiting room”.
2 Convergence criteria
2.1 “Each Member State must meet all of the criteria in order to participate in the third stage of Economic and Monetary Union (EMU). These are specified in the "Protocol on the convergence criteria" referred to in Article 121 of the Treaty establishing the European Community. They reflect the degree of economic convergence which the Member States must attain to be able to introduce the euro.”4 Due to the significance of the criteria I would like to discuss the compatibility of the Bulgaria economy concerning each criteria.
2.2 Inflation rates - no more than 1.5 percentage points higher than the average of the three best performing (lowest inflation) Member States
2.2.1 Inflation is measured through statistical index (HCPI) composed by the prices of specific products for general use
2.2.2 That index is measured by the statistical agencies of the Member States and Eurostat (with some methodological differences) and the Bulgarian one is directly subordinated to the government
2.2.3 Although the inflation index for 2009 is down to 2.5% (from 12% in 20085) it is significantly higher than the 0.3% average for the EU.
2.2.4 The Bulgarian statistical agency estimates for the inflation differ from those of Eurostat with 0.9%6 which naturally makes eyebrows move upward.
2.2.5 It should be quite obvious that Bulgaria does not cover this specific criteria.
2.3 Annual government deficit: the ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding financial year.
2.3.1 The main problem in Bulgaria is to establish the exact budget deficit- this will be discussed in more details later on.
2.3.2 In any case the government argues that the deficit is less than 0.5% and it has substantial stability due to decade of budgetary surpluses.
2.3.3 In the 2010 the budget of the central government is with deficit of 250 million Euro, however there is defined uncertainty about the tax income.
2.4 The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding financial year. This is clearly the case where the government debt is just about 17% and is perhaps the only undisputed criteria.
2.5 The Member State must have participated in the exchange-rate mechanism of the European monetary system without any break during the two years preceding the examination of the situation and without severe tensions.
2.5.1 The exchange rate is fixed by an inflexible currency peg for over a decade, which in practice gives the exchange stability required by the rule.
2.5.2 It could be speculated though that the longer term stability of the peg depends on the inflow of capital in the country. Such inflow is highly volatile and the statistics suggest problems ahead (more detailed analysis below).
2.5.3 Unless the competitiveness of the Bulgarian economy is not increased in short to medium term the sustainability of the peg (hence the exchange rate) may be endangered.
2.6 The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states
2.6.1 According to the statistics of ECB7 the average interest rate in Bulgaria for 2009 is above 7%. The country with highest interest rates in the Euro-zone was Greece – around 5%.
2.6.2 However the Member States with lowest inflation – Belgium, Holland and Germany have longer term interest rates 3 to 4% lower than the Bulgarian one.
3 Budgetary reporting
3.1 Budgetary reporting stays as a great problem for any independent analyst – it is recorded on the cash bases only.
3.1.1 When the government actually makes the payment it is recorded as such, while if it only takes the liability there is no trace in the budget reports
3.1.2 This practice was used by the last government (and by the current one) to take large liabilities and report budgetary statistics far better than the actual results.
3.2 The budget is getting dangerously unstable due to lack of political will to disclose the real amount of liabilities taken by the taxpayer.
3.2.1 With only limited resources the Ministry of Finance will need to delay payments and damage its reputation as reliable borrower
3.2.2 The presumable large amounts that are payable to the business, but not forecasted in the budget (according to the Association of Employers that sum is close to Euro 0.75 billion) can create serious liquidity problems for the budget account.
3.2.2.1 Recently the government revised its GDP growth forecast to 0.3% from -2%. In my opinion this is extremely optimistic, but even if a miracle happens and Bulgaria gets out of the recession in late 2010 I can not see how this will increase the willingness of the population to fill the state coffers.
3.3 It is important to mention the inability of the government to sell its treasury bills to the central bank under the rules of the currency peg, which gives only two actual choices for substantial fund-raising:
3.3.1 Sell bonds to external investors (with Greece in bad shape and BBB rating of the country that may prove though act). This will also be reported as one time income which will likely cause moral hazard in the budget analysis.
3.3.2 Sell T-bills to the local market. Though such idea has many advantages having in mind the budget instability and liquidity crises (see the following section) it may prove impossible
3.4 I am afraid that unless the government cleans its act about the actual size of public debt (and its reporting standards) there could not be sustainability in the budget planing and execution.
4 Economic policy – liquidity crises with large reserves
4.1 The government states that it has more than Euro 3.5 billion as fiscal reserve raised by budget surpluses from previous periods.
4.1.1 The National Bank has the above sum on its balance sheet
4.1.2 The government is thought to have enough support to change the budgetary regulation concerning the fiscal reserve
4.2 There is not substantial cash in the budget for all the payments due. The government is clearly experiencing liquidity crises.
4.2.1 That is the official position of the Minister of Finance8
4.2.2 There are various officially recognized central budget liabilities (like those to the winter road maintenance companies) not settled for months
4.2.3 In the end of 2009 the payments to the judicial authority were not honered by the Ministry of Finance and the issue was resolved in early 2010. The explanation – the money in the government settlement system were “not actually there”
4.3 I will explore two plausible and one quite unlikely explanations for such contradictory behaviour
4.3.1 The official position (and the most unbelievable case among the three I explore) is that the government needs to sustain high reserves to boost its application for ERM 2
4.3.1.1 In this line of thinking the suppression of expenses in 2009 was just an accounting trick to beef up results
4.3.1.2 Naturally the question of honesty in reporting (especially after the Greek statistical fiasco) is cornerstone towards any evaluation procedure – hence the drive of official to explain the official accounting deception is hard to believe
4.3.1.3 What is more the suppression of expenses is causing liquidity problems to the hardest hit by the global crises business field – construction. Driving large number of employers into bankruptcy is hardly an economic policy any government would conduct willingly.
4.3.2 Further speculations suggest that the government expects high net (cash-flow) deficit for the first half of the year, hence it will need more money to meet its financial obligations.
4.3.2.1 Most certainly this is realistic scenario. The government would expect around 12 billion Euro in revenues in 2010, with good half of them due in the first six months.
4.3.2.2 There are some inconsistencies however – the economic revival in the second half of 2010 could be soured by liquidity problems and there is no real need to suppress expenses
4.3.2.3 From political point of view it is also problematic why the deficit induced by the previous government is transferred in the new fiscal year.
4.3.3 The third option concerns the quality of the reserves – or should I say their solidity
4.3.3.1 I must underline that this option is entirely speculative and although it fits the observable facts quite well there is not a single proof to validate it
4.3.3.2 The fiscal reserve (and the currency reserve) are managed by the National Bank. They are stored in low-risk securities – what precisely is not public information.
4.3.3.3 Supposing that the reserves have been involved in transactions with much higher risk and the resulting profit has been banked privately (the interest of 12 billion Euro – the reserves - is considerable)
4.3.3.4 The next step is the involvement of the world economic crises where the high risk investments go bust.
4.3.3.5 Resulting in, with elegant inevitability, not only sizeable loses that can not be admitted, but also considerable solidity of the investments. Hence the government may not use its fiscal reserves simply because they may not pull them out from their current investment.
4.3.3.6 I must underline once again the pure speculative character of this option. The National Bank publishes information about its balance sheet every week, where there are over 1 billion Euro in cash, 1 billion in gold and 10 billion in securities.
4.3.3.7 To give further information (undermining my speculation) I would note that in the mids of the recession the cash position in the balance sheet was closer to 2 billion, further information you may find at http://bnb.bg/Statistics/StBNBBalances/StBalancesIssueDepartment/StBIDMonthly/index.htm?periodAndRatesStartMonths=01&periodAndRatesStartYear=2008&periodAndRatesEndMonths=01&periodAndRatesEndYear=2010&active=306&active=309&active=310&active=314&downloadOper=&selectPeriod=true&search=search&toLang=_EN
4.4 Whichever option is the correct one – there conclusion is the certain. Bulgaria is not in the necessary economical shape to be part of the ERM2.
5 Banking system
5.1 I will start this section with a news from the National Bank. As from December 2009 the reported loans (overdrafts excluded) are 19.7 billion Euro. Out of those the non-performing are 2.1 billion or the looping 10.8%9.
5.2 It is still unclear if all those loans will need to be liquidated and what would be the collateral liquidation price, however it is inevitable that large loses will be made.
5.3 A deposit war between bank institutions is raising the long-term interest rates 3 and more percent above the EU average. What is more it is unlikely to drive the difference down in near future.
5.4 If the economic recession persists and the non-performing loans increase (as expected) the banks may have cash-flow problems – pretty much like the government itself. The only difference being the government may refuse payments.
5.5 Due to the relatively recent bank crises of 1996 the general population is considered prone to bank runs. Therefore the government will need to bail-out any bank that finds itself in serious trouble.
5.5.1 Following the rules of the currency peg the government may not print its way out of such situation
5.5.2 Furthermore public action in the bank sphere may cause public anxiety
5.6 In case of a banking crises the currency peg is likely to experience severe challenge. Currently it is based on the National Bank reserves, however if a bail-out is needed of the tune of few billion (in result to bank run) it is unclear if any international institution will pump enough liquidity in time.
6 Predictions
6.1 Legal notice
6.1.1 According to the Penal Code of Bulgaria anyone who undermines publicly the financial system is criminal liable to up to 5 years in prison.
6.1.2 In respect to the above nothing of this post may be considered as undermining of the Bulgarian financial system. I think it IS stable and WILL endure all challenges.
6.1.3 Naturally even if I do not think it I am obligated to say it.
6.2 ERM 2 and my recommendation
6.2.1 Bulgaria is effectively answering only two of the convergence criteria
6.2.2 Even though there are not set entrée rules for ERM2 it is implicit that one needs to cover the convergence criteria and stay in the mechanism to prove sustainability
6.2.3 I think Bulgaria is not ready
6.2.4 It would appear that the ECB has the same opinion, since after the European Council in February the Bulgarian PM suggested the ERM2 is “few years away”
6.3 I feel like Cassandra.
6.3.1 Sometimes I also feel like Cassandra. You know the one who used to say: “I told you so”
6.3.2 I think there is NO problem in the banking system (see legal note)
6.3.3 I think the government HAS easy access to all of its reserves, well and safely managed
6.3.4 I think the currency peg is STABLE
7 Thank you for reading....