Monetary, Credit, Financial and Exchange Rate Policies in Bulgaria: objectives and implementation

Zdravko Balyozov (*)


The changes in the banking sector are an important part in the process of transition from a centrally planned to a market economy which started in Bulgaria since 1991. The institutional framework of the emerging banking sector is developed on a sound new regulatory basis. It contains the Law on the Bulgarian National Bank (BNB), effective as of June 1991; the Law on Banks and Credit Activities, effective as of March 1992; six Banking Prudential Regulations; an Ordinance of Payments and a number of regulations regarding government securities and use of monetary instruments.

According to the law the BNB is given the typical functions of a central bank as well as of banking supervision in the country. The law says that the Bank is to perform its functions 'independent from the Council of Ministers and other state bodies' and being 'accountable to the National Assembly for its activity'. Twice a year the BNB has to submit to Parliament annual and semi-annual reports on its policy and operations. The Governor and the three Deputy Governors, elected by Parliament, together with five heads of major departments, appointed by the President, form the Managing Board of the bank for a five year term.

At present there are over 40 commercial banks operating in Bulgaria. Most of them have emerged either by the consolidation of smaller state owned banks or as newly started private banks. Several banks are branches of foreign banks or have foreign participation.

The non-bank part of the financial sector includes over 200 financial and brockerage houses and several hundreds exchange bureaux. Two stock exchanges are functioning but the domestic financial market is still underdeveloped the major obstacle being the lack of legal framework.


The monitoring of the money supply

The BNB follows its major goal to keep the internal and external stability of the Bulgarian lev using market oriented monetary instruments. To control inflation it usually targets broad money which includes currency outside banks and all types of deposits. The money supply expansion is monitored within a reserve money management framework. The annual and quaterly benchmarks concerning the growth of money are approved by the Managing board while the specific mix of monetary instruments to follow a predefined path is decided by a Monetary Policy Implementation Committee operating on daily basis.

The major constraint on monetary policy is the decline in the demand for real money balances typical for high inflation environment. In 1994 the problem aggrevated due to an increase in the demand for foreign exchange which followed the sharp depreciation of the lev in March. The loss of confidence in the domestic currency further limited the credit resources to the government and non-government sectors and thus exerted pressure to loosen the monetary policy.

At the same time the fragility of the banking sector was also encountered. Two big state owned banks began to experience liquidity problems due to a considerable mismatch in the yield and maturity of their assets and liabilities. This was the result mainly of a stock problem arising from the implementation of a law which led to the substitution of non-performing credits given to non-financial public enterprises before 1991 by low-income government bonds. The financial position of the banks further deteriorated due to flow problems connected with their current activity which included the extension of new credits to insolvent state owned and private enterprises. To keep the liquidity of the banking system the two ailing banks had to be refinanced regularly by the central bank. This was to be done regardless of the overall monetary restriction targeted for 1994 and finally accomodated the accelerating inflation which reached 122% by the end of the year.

Instruments of the monetary policy

Various instruments are being used to conduct monetary policy by the BNB. The general tendency is gradually to abandon tools of direct control and replace them with indirect market-based ones. This is also supplemented with measures to stimulate the development of the financial markets.

At the beginning of the reform in an environment of a continuing disequilibrium in the national economy accompanied by the lack of a money market, credit ceilings were the main monetary instrument to control credit expansion. During the period of about three years in which this tool was used it underwent considerable changes to mitigate the deficiencies of its direct nature. Overall limits were defined on the basis of the projected money supply consistent with the final inflationary target. In the allocation among banks the weight of the credit market share of each bank decreased while the weights of the capital base and the growth of deposits increased. Since June 1994 credit ceilings have been abandoned because more efficient market oriented monetary instruments had been developed and extensively used.

At present the major tool for adding or taking out liquidity every day is open market operations. They are performed both in short-term treasury bills and long-term government bonds including those issued to replace non-performing loans given to state owned enterprises. The preferred operations are repurchase agreements which guarantee efficient short-term bank liquidity management.

Refinancing is the traditional and currently most important type of central bank lending to commercial banks in Bulgaria. Several facilities are used: lombard window, discount window, short-term BNB deposit to commercial banks. The lombard loans extended by the BNB are against collateral of government paper, gold or foreign exchange. Being collateralized these loans contribute to improve the quality of the banks' assets by increasing their average liquidity and respectively lowering the credit risk.

The liquidity of the treasury bills enhanced by the lombard facility fosters the development of the secondary market in government securities. This creates favourable conditions for a part of the budget deficit to be financed through purchasing government securities by households and non-financial enterprises which will ensure the non-bank non-inflationary financing of the government borrowing.

Discount operations may be considered as an indispensable indicator for the transactional demand for money resources. Notwithstanding their limited application at present they are an efficient mechanism for monetizing the commercial credit. The relatively low amount of this type of operations is mainly due to the lack of banking products to provide the extended use of bills of exchange. It is expected that the future will witness a quicker development of discount operations.

The short-term deposits are given to the commercial banks by the BNB as a lender of last resort. This facility is being widely used to refinance ailing banks after all their government bonds had been blocked as a collateral for extended lombard credits. Small amounts of these deposits are also given to cover accidental liquidity shortages of some banks which are also visited by banking supervision experts to find out the causes for their problems.

In the absence of a specialized financial institution to credit export and import operations the BNB is temporarily engaged in refinancing in foreign exchange. Two different facilities are used: discount loans in foreign exchange and BNB foreign exchange deposits in resident banks. These instruments have certain beneficial effect for the export orientation of the real sector but do not stimulate the demand for real lev money and therefore are applied on a limited basis.

Minimal reserve requirements are also used as an important instrument to tighten or loosen the exerted monetary restriction. In the last two years a gradual increase from the level of 7 to the level of 12% is being witnessed as an effort to cut down inflation and return confidence in the lev. Some privileges concerning the interest charged on these funds have been developed to stimulate the sales by banks of government paper to the non-bank public which has an important anti-inflationary effect.

Interest rates are also an important monetary instrument. According to the Law on the BNB the central bank defines the basic interest rate which is used when the budget deficit is financed by a direct credit. This interest rate strongly affects interest rates at the interbank market as well as lending and deposit rates charged by commercial banks. During the reform period the BNB has often changed basic interest to tighten or loosen its monetary policy. When inflation goes up or there is a growing pressure for a depreciation of the lev basic interest rate is usually raised, while in periods of relative financial stability it is cautiously lowered down. In 1994 the BNB within its overall restrictive monetary policy raised it three times increased it up to the highest so far level of 72% simple annual rate. In the second quarter of 1995 having cut monthly inflation to 3-4% by strict control of reserve money and money supply the central bank started a process of gradual decrease of basic interest rate, the first step being to lower it to 65%, the second - to 60%, the third - to 54%.

Interest rates charged by commercial banks on credits and deposits remain closely connected with the basic interest rate. In 1994 although they were very high in nominal terms, their real values when deflated by the consumer price index (CPI) become quite different. For the whole year depositors lost in real terms over 25% and this was the main reason for the beginning of the currency substitution process. Real price on credits is also negative (about 8%) if deflated by CPI, but turns out positive of the same amount if deflated by the producer price index for industry which is a heavy burden on the real sector.

With inflation going down in 1995 the BNB will define its basic interest rate in such a way to keep the real interest rates on deposits marginally close to zero and on credits - slightly positive. This seems to be a sustainable tradeoff between the effort to regain confidence in the lev and the necessity to support real sector growth through a better investment environment.


Overall financial policy of the BNB is aimed at keeping and strengthening the financial stability achieved at the beginning of the reform. As time goes it becomes evident that it is more and more difficult to do this by restrictive monetary policy only when privatization and structural reform in the real sector is lagging behind. The most important issue to be addressed in 1995 is how to combine the revival of the real sector with moderate restriction on monetary, fiscal and income policy to create environment for an anti-inflationary economic growth in the medium term.

In 1994 a considerable improvement in the external financial position of the country was achieved. After the agreement reached on the restructure and reschedule of the external debt to the London club in June 1994 Bulgaria resumed to service it regularly. Nevertheless the country is still isolated from international money markets and the foreign inflow is limited to the official financement. It even does not cover the external payments so the net foreign financement is negative. No significant changes are expected for 1995 - the trade balance will continue to be in surplus and together with eventual foreign inflow will finance the external payments.

In such an environment the major financial source for domestic credit remains to be domestic savings. The room for its nominal expansion is defined mainly by the nominal growth of the money supply which is to be consistant with the inflation target. To achieve the aimed considerable decrease in inflation in 1995 and leave enough credit for the real sector the demand for bank financement of the budget deficit should not exceed about 3% of GDP. Any increase over this level will have to be financed from domestic non-bank and/or from foreign sources to prevent further crowding out of the real sector on the credit market which will endanger the envisaged economic growth.


At the beginning of the reform in 1991 Bulgaria chose the option of independent float of the domestic currency to the US dollar. Technically it is implemented by the BNB quoting daily the central exchange rate of the lev to the american currency. This rate is a purely market oriented variable being totally based on the rates charged by major commercial banks on the previous day. The foreign exchange regime of the country allows convertibility of the lev on the current account. Bulgarian enterprises and households may also have foreign exchange deposits in resident banks.

As an integral part of the BNB's monetary policy the main objective of the foreign exchange policy is the external stability of the lev. Under the regime of floating exchange rate with high domestic inflation there are three tasks to be considered. The first is to secure the relative stability in the nominal exchange rate. To achieve this the BNB aims at supporting the lev at such a level against the US dollar which would not exert inflationary pressure in the country, but would preserve the competitiveness of the Bulgarian export. The second task is to smoothen the nominal fluctuations in the exchange rate which cause uncertainty in the foreign trade activity and undermine the confidence in the lev. And last but not of least importance is to keep foreign exchange reserves at a level providing for stability in foreign trade payments, effective interventions in the domestic foreign exchange market and since 1995 service of the foreign debt.

These tasks have been achieved in the first two and a half years after the start of the reform. In the second half of 1993 and first quarter of 1994 there was a growing pressure on the foreign exchange market mainly due to a deficit in the balance of payments and lack of official financing. This led to a sharp depreciation of the lev in March 1994 which was followed by some appreciation after official financement resumed. Since October 1994 when more restrictive monetary policy was adopted the lev became stronger the BNB has been able to fill its reserves buying the excessive amounts of foreign exchange coming from the positive balance of payments. In the first quarter of 1995 the country has been able to meet all its external payments without losing reserves which creates the proper environment for further service of the debt throughout the year.

The first months of 1995 mark a certain improvement in the overall macroeconomic situation in the country. Inflation is going down, more branches of industry have positive real growth, unemployment also decreases. The revival of the real sector is supported by prudent fiscal and monetary policies: income policy and fiscal expenditures remain under control and the central bank has started a process of gradual decrease in interest rates at the same time purchasing the excessive amounts of foreign exchange coming from the positive balance of payments. Nevertheless the results so far, the achieved financial stability still remains rather fragile. It creates the proper environment for a non-inflationary growth in the medium term but the latter can be sustained only through a full commitment to quicken the structural reform through privatization and foreign capital promotion.


(*) Ph.D. - Head of Economic and Monetary Research Department, Bulgarian National Bank/Bulgarska Narodna Banka. 1 Alexander Battenberg Square - 1000 Sofia Bulgaria.