Monetary developments in Bulgaria in 1995-1998

Zdravko Balyozov*

1.INTRODUCTION

The years 1995-1998 are a period of controversial developments in monetary policy and the banking system in Bulgaria. 1995 was a year of relative financial stability brought mainly by monetary tightening which however, being not supported by radical structural changes in the real sector, turned out not to be sustainable. In 1996 there were growing pressures for the depreciation of the lev coupled with massive withdraws of deposits from the banking system. The attempts of the Bulgarian national bank (BNB) to reinforce monetary control by traditional instruments failed because of the continuing lack of decisive measures in the real sector. A severe banking crisis developed in which about one third of the banking sector stopped operating. The loss of confidence in the lev and in the banking system was immediately followed by a deep economic crisis which at the end of 1996 turned into political. In early 1997 the national currency devalued dramatically and the country was pushed to the verge of hyperinflation. A democratic solution to the political crisis was found through early parliamentary elections based on a political agreement for radical economic reform. It included the introduction of a currency board as a change from traditional discretionary monetary policy. Since than financial as well as macro-economic stabilization has been achieved, the banking system revived and economic growth restored. To make this process irreversible further commitment and continuation of the started reform is crucial.


2.FINANCIAL INSTABILITY AND CRISIS (1995-EARLY 1997)

2.1 The origin of the crisis

The roots of the financial collapse in late 1996 and early 1997 should be traced to the previous years when governments changed often before their term expired and that led to stop-and-goes in the structural reform. All stabilization measures since early 1991 failed because the necessity for a radical and consistent change in the real sector was ignored. The financial and banking crisis of 1996-1997 clearly proves that it is not possible by monetary tightening to compensate the delays in the structural reform and the more these unpopular measures are postponed the deeper crisis finally hits. After the first exchange rate crisis of March 1994 relative financial stability was achieved in 1995: the end-of-period inflation went down from 122% in 1994 to 33%, while real GDP growth slightly increased to 2.1% from 1.8% in 1994. The monetary policy of the central bank was substantially tightened since the second half of 1994 and throughout 1995 remained mainly restrictive. Following its anti-inflationary target the BNB was able to lower the basic interest rate step by step from 72% to 34% but real rates on deposits and credits remained positive. This had favorable effect on savings and the demand for money while the real price of credits turned out to be too heavy for most of the borrowers. A considerable interest rate differential between lev and foreign currency instruments was also preserved for the greater part of the year which resulted in a strong capital flow. Foreign exchange reserves were replenished and thus the service of the external debt was ensured although there was no official financing. The larger part of the foreign exchange inflow was sterilized by the BNB using open market operations and raising the reserve requirement. In 1995 real money supply measured by the broadest monetary aggregate which includes currency outside banks and all types of deposits grew by 5%. A certain return of confidence to the national currency was also observed: the lev component increase was over 86% of the total. For the first ten months the foreign reserves of the BNB (including gold) grew from 1310 mln. USD at end-94 to 1774 mln. USD, but declined to 1545 mln. by the end of the year. In the meantime delayed privatization as well lack of financial discipline were deepening the fundamental problems. Many state-owned enterprises continued to accumulate losses and to transfer them to the banking system using soft credits. This together with poor lending practices led to the decapitalization of a number of banks which was quickly realized by depositors. In late 1995 their first runs on some banks found them illiquid and to support the payments system the BNB began refinancing them as lender of last resort. Lacking an effective mechanism for the forced collection of claims and bankruptcy these measures could only postpone the problems but at the expense of a future crisis.

2.2 The banking crisis

In the first months of 1996 the BNB increasing role as lender of last resort heavily contradicted the general anti-inflationary orientation of its monetary policy and exerted growing pressure to loosen it. The quickly increasing unsecured credits to troubled banks could not be sterilized by open market operations and the remaining liquidity continuously channeled to the foreign exchange market. Initially the BNB tried also to support the national currency but when its foreign reserves came down to a critical level that threatened foreign debt service through year-end the lev was let to depreciate freely. This further decreased the confidence in it as well as in the banking system which could not be reinforced even by raising interest rates to the unprecedented to that time level of 108% in early May 1996. After passing the necessary legal framework for closing banks and protecting depositors at the end of May BNB put under conservatorship several banks and subsequently applied to court to start bankruptcy proceedings against them. The isolation of non-viable banks however also had no lasting effect because confidence was already undermined and the country entered into a deep financial and banking crisis which began quickly to paralyze the real sector. The confidence in the lev and the banks was not restored even after the disbursement of the first tranche under a hasty stand-by agreement signed with the IMF. Privatization and closing loss making enterprises in the real sector however was again delayed which together with the continuing financial instability contributed to the delays in the official support. To prevent a government default on its domestic debt the BNB was forced to ease its monetary policy. The central bank began to buy the unsold issues at the primary auctions for government securities and tha n do open market operations with them at the secondary market. Naturally this had an increasingly inflationary and disturbing effect both on the banking system and the financial markets. At the end of September 1996 the BNB made its final effort to restore financial stability through a package of restrictive measures. It involved 1)the isolation from the banking system of nine more banks (thus their number becoming 15 - about one third of the total number of banks) by appointing there conservators, 2)raising basic interest rate to 25% monthly to achieve a real positive level and 3)offering support for viable banks using various monetary instruments. The substantial monetary tightening had only temporary effect because again was not supported by actions in the real sector to fulfill the requirements under the stand-by agreement with the IMF. In early November it was finally halted and a currency board arrangement was proposed as an element in a new stabilization package to resume the access to official financing. In 1996 real money supply contracted by 45%. The decline was especially strong in quasi-money: saving deposits real drop was almost 70% and 890 mln. USD of foreign exchange deposits were withdrawn which was 42% of their total. Foreign exchange reserves of the BNB were reduced by over 750 mln. USD and at the end of the year were only 792 mln. USD. In late December the government resigned and the National Assembly decided for the BNB to extend a direct credit to the government totaling over 6% of GDP to meet all its financial needs pushed to the end of the fiscal year. To prevent a complete disruption of financial markets in the country the central bank extended the credit which practically removed the last barrier to a sharp depreciation of the lev and hyperinflation following it in early 1997.


3. FINANCIAL STABILIZATION AND REVIVAL OF THE BANKING SYSTEM

3.1 The background for the Introduction of a Currency Board

In early February the political crisis was resolved in a democratic way: an agreement between the political forces about the principles to save the country was reached which included early parliamentary elections, introduction of a currency board by the new National assembly and radical structural reform. The appointed by the president caretaker government rapidly acted to restore financial stability. It began to refrain from net borrowing from the central bank and provided budget deficit financing through proceeds from privatization and market-based sale of short-term securities. This policy was supported by the BNB which stopped net lending to commercial banks. High confidence in the new government as well as restrictive fiscal and monetary measures resulted in appreciation of the lev and quick end to the hyperinflation. The commitment to radical change was swiftly and significantly backed by the IMF. The new stand-by agreement reached in April 1997 played the role of financial anchor for the forthcoming la unch of a currency board. After the political decision to introduce a currency board was taken the BNB began the preparation for the new monetary arrangement. It started to adjust its monetary instruments reducing significantly their influence on the liquidity of the banking system. The discretionary way of setting the basic interest rate was gradually abandoned and tied to the yield to maturity of short term government paper on the primary market. New lombard and discount credits were stopped while old ones from operating banks were collected. Finally in mid-June open market operations were also terminated and the only monetary instrument left to the BNB was the minimal reserve requirement. This policy was combined with predominant purchases of foreign exchange at the domestic market which provided the necessary liquidity for the budget and the banking system and replenished the reserves of the central bank. In the months March to June the growing constraints on BNB monetary policy did not affect its efficiency. Because of the good c oordination with the government and the wide public support for the reforms monthly inflation went down from 243% in February to 2% monthly average for the second quarter, basic interest rate fell from 18% monthly in March to 10.12% simple annual rate at the end of June and foreign currency reserve of the BNB grew from 717 mln. USD at the end of February to 1626 mln. USD at the end of June.

3.2 The Currency Board Arrangement

In June 1997 the newly elected National Assembly passed new laws on the BNB and on commercial banks which provide the legal basis for the introduction of a currency board and the development of the banking sector. The currency board was set up within the BNB as a separate department and all the other functions of the central bank were tailored to be consistent with it. The currency board arrangement in Bulgaria strictly follows the major principles of this monetary regime: full coverage of all monetary liabilities by liquid foreign exchange assets, unlimited exchange of national currency to reserve currency and vice versa at the fixed exchange rate, prohibition to refinance both commercial banks and the government. At the same time its implementation has some specific features which do not contradict the major scheme but reflect the situation in the country. The German mark was chosen for reserve currency as a strong anchor which also facilitates Bulgarian accession to the European Union. The level of fixing is 1000 levs for 1 German mark. The BNB is obliged by law to sell and purchase German marks against levs up to any amount within the territory of the country on the basis of spot exchange rates, which may not diverge from the official fixing by more than 0.5%, inclusive of any fees, commissions and other charges to the customer. In compliance to that the BNB buys 1 DEM at 995 levs and sells it for 1000 levs at the domestic foreign exchange market and also in cash to the public at the counters at its headquarters and branches over the country. Institutionally the BNB is divided into two departments with separate balance sheets: Issue department and Banking department. The first one takes the functions of a currency board and its balance sheet includes the most liquid assets (only foreign reserves) and liabilities (currency in circulation, banks' reserves and government deposits). The latter takes the residual part of the balance sheet of the BNB and its other central bank functions beside banking supervision which is separated in a third major department. The BNB publishes the balance sheet of the Issue department weekly and the balance sheet of the Banking department monthly, thus providing full transparency of all assets and liabilities movements in them. So the first specific feature of the Bulgarian currency board is the full coverage by foreign reserves not only of traditional monetary liabilities (reserve money) but also of government deposits with the BNB to ensure its capability to meet external and internal debt service. The link between the Issue and the Banking department is maintained by the so called deposit of the Banking department with the Issue department which in essence is the net positive value of the currency board equal to the excess foreign reserves over reserve money and government deposits. It can be used by the BNB to intervene as lender of last resort only in case of a systemic banking crisis. This is another specific feature of the currency board in Bulgaria. It is consistent with the general principles of the arrangement as any eventual refinancing is fully covered by foreign reserves. It reflects the remaining fragility of the banking system after the deep crisis in 1996. A third specific feature of the Bulgarian currency board is the BNB right to extend credit to the government solely against purchases of special drawing rights (SDR) from the IMF. It should not be considered a break from central bank independence or from the general currency board rules because the BNB in practice only channels Fund credit to the government. This feature is also related to the considerable external indebtedness of the government which at the same time has to make structural changes in its budget. Banking supervision is tightened to compensate for the limited lender of last resort function of the central bank. Substantial changes were made in major regulations for prudential banking and some additional ones were introduced. The new regulation on the capital adequacy of banks establishes more stringent requirements: minimal capital adequacy is raised in steps: 8% by end-97, 10% by end-98, 12% by end-99. The minimal capital required for a bank was also increased to 10 bln. levs (10 mln. German marks) and became effective in mid-98. The new regulation on foreign currency positions of banks excludes the German mark from the set of foreign currencies and with the introduction of the euro this regime is extended to all its national denominations. A special regulation on liquidity management and supervision was passed focusing on effective monitoring cash flows of banks. In the first eighteen months of its functioning the currency board is very successful. This is reflected in a substantial increase of foreign currency reserves while the lender of last resort function has never been used. In the first six months the growth of reserves is strongest: from 2.8 bln. DEM at the start to 4.4 bln. DEM at end-97 which is almost 60%. For 1998 the increase is smaller - by 0.7 bln. DEM which is over 15%. The biggest rise in reserves is to cover the growth of currency in circulation - by 821 bln. levs until end-97 and by another 425 bln. levs in 1998. The deposits of the government also increase substantially: by 448 bln. levs until end-97 and by 348 bln. levs in 1998.

3.3 The Revival of the Banking System

The first signs of financial stabilization following the change in fiscal and monetary policy had a positive effect on the banking system. The return of confidence to the national currency as well as to the banking system became much stronger after the introduction of the currency board. It resulted in substantial remonetization compared to the very depressed level in February and strengthening of banks' financial and capital position. For the second half of 1997 money supply rose by 2000 bln. levs which is 30% in real terms. The real growth of the lev component was over 80% and contributed for 90% of the total increase. By end-97 its share in broad money exceeded 56%, against 40% in June and only 25% in February. In 1997 the banks substantially improved their capital adequacy ratios and allocated provisions to cover the doubtful part of their assets. The major source of these provisions were net earnings on valuation adjustments due to the sharp devaluation of the lev at the beginning of the year. The overall improvement in the macro-economic environment led also to an increase in the market prices of most of the government securities held by the banks and thus had a positive effect on their capital and financial position. Tighter lending terms combined with real depreciation of banks' liabilities due to the hyper-inflation reflected in a substantial improvement in the banks' liquidity at the start of the currency board. After its introduction substantial changes in banks' behavior are noticeable. They are: 1)preference to maintain high liquidity at the expense of lower profitability, 2)decline in the share of valuation adjustments in total financial revenue as a result of the fixed exchange rate, 3)limited credit act ivity as a reflection of the still remaining high risk in the real sector and the tightened bank supervision regulations and their enforcement by the BNB. In 1997 the capital of the banking system increased over six times and its share in the total liabilities of the banks increased from 5% to 12%. It was the result of capitalizing net profits. The capital adequacy ratio of the banking system at end 1997 was 23.4% against 10.8% at the end of 1996. The credit risk in the banking system greatly declined: at the end of 1997 the share of standard loans and exposures reached 83%, from 47% a year before. The liquidity of the banking system also substantially increased - the ratio of high liquid resources to attracted funds grew from 41% in June 1997 to 49% at the end of the year. In 1998 the stabilization of the banking system has continued. The annual real growth of the money supply is about 9% and only of its lev component - 17%. Its share in total broad money has further increased to almost 60%. By end June 1998 the share of equity capital in total banks' liabilities reached 14.4%. By August all operating banks complied to the minimal capital requirement of 10 billion levs. By mid 1998 the capital adequacy ratio of the banking system increased to 36.8%, all banks reported ratios above 10% (the minimal level for end-1998) and only one - below 12% (the minimal level for end-1999). The conservative lending practice continued and the share of standard exposures further increased to 86.7%. Most of the banks continued to maintain high liquidity: long term investment was limited while preferences remained for cash balances, government securities and deposits abroad. Compared to the crisis period the banking system has greatly stabilized and is further strengthened by the real growth of money, improved lending incentives and practice as well as tightened banking supervision. However, the return of confidence to the national currency and to the banking system is a lengthy process which is expected to take long time before pre-crises levels of monetization are reached. At the end of 1998 the ratio of broad money to GDP is about 30%, while at the end of 1995 it was over 65%. For the same three year period the share of credits to the real sector in GDP also has declined from about 40% to 17%. After the banking crises the extremely cautious credit policy of the banks puts pressure on their profitability and their further recapitalization. The growing capital adequacy ratios show also lack of viable projects to be credited. Under the currency board arrangement the banking system is completely opened to external and internal shocks and its stable development is a big challenge both to the commercial banks and the central bank.

3.4 Bank Privatization

The transition to a market oriented economy based on a strong and effective banking sector is closely related to bank privatization. This is also the key issue to resolve most of the remaining problems under the currency board arrangement. Such a decision has been taken by Bulgarian authorities and a program for its implementation is under way. The major goal in bank privatization is to sell all state owned banks to foreign strategic investors who are expected to further capitalize them, to raise the quality of their service and expertise as well as their profitability, Finally in case of liquidity crisis the dominance of foreign banks may compensate the limited role of the central bank as lender of last resort under the currency board arrangement. Before the privatization process started the state share in the banking sector was over 80% and was concentrated in seven large financial institutions. The first Bulgarian bank was privatized in mid-1997 - the United Bulgarian Bank was sold to a consortium of foreign and domestic strategic investors. In the summer of 1998 a second Bulgarian bank - Bulgarian Post Bank was also sold to foreign investors. In 1999 preparation for the privatization of two other banks is under way - for Bulbank, which is the largest state owned bank and for Expressbank. Well established international intermediaries are hired to accomplish these privatization deals and the bidding procedures for one of them is to start by the end of the first quarter and for the other - by the end of the first half of the year. The privatization of the fifth bank, Hebrosbank is also in progress and is expected to be finished by the end of 1999. The sixth bank, Biochim has started a two year management contract with an international partner which is to prepare it for privatization. The seventh institution, the State savings bank is in a two year transitional period to be transformed into an universal bank after which it is also to be privatized.


4. THE PROSPECTS FOR THE CURRENCY BOARD AND THE DEVELOPMENT OF THE BANKING SYSTEM From January 1, 1999 the Bulgarian lev is fixed to the euro using the irreversibly fixed exchange rate of the German mark to it. Thus the new official fixed exchange rate is 1955.83 levs per euro. This procedure was envisaged in the BNB law passed in mid-1997 and was strictly followed by the management of the bank. The fact that there was no devaluation whatsoever reaffirms the commitment of the Bulgarian authorities to follow the chosen path of financial stability and integration to European structures. As the currency board has produced spectacular results the intention is to preserve it as an anchor of stability at least until the country enters the European Union. Furthermore it is also expected to be beneficial for joining the European Monetary Union in the longer prospective. The banking system will continue to develop in a currency board environment. As the country has further opened fixing the lev to the euro, Bulgarian banks face stronger competition and challenges. The quick privatization as well as the overall change in the real sector are expected to lower the credit risk and cut the interest margins without affecting the profitability of the banks. At the same time banking supervision from the BNB will continue to play an important role for the stability of the banking system.


04-02-1999


* Head of Statistics and Operational Analyses Directorate, Bulgarian National Bank Z.Balyozov@bnbank.org