Bulgaria’s weak macroeconomic performance in the first half of the 1990s culminated in a severe economic crisis in 1996 and early 1997. The banking sector was at the heart of the crisis – it was plagued with non-performing loans, weaknesses in governance and unsound credit policies to finance consumption, income transfers, price subsidies and inefficient
production. Nine out of the ten state-owned banks, which at that time accounted for over 80% of banking sector assets, had negative capital, and about half of the private banks were technically bankrupt as well.

Early attempts to restructure the sector included bank closures or recapitalisation, the signing of a Memorandum of Understanding and changes in the regulatory and legal framework. The credibility of the package, a major element of which was conservatorships imposed by the Bulgarian National Bank (BNB) in September 1996, was, however, undermined by the failure to implement key supportive policies such as the privatisation of state-owned banks and enterprises and the closure of loss-making enterprises. In the end, the banking crisis led to the closure of 17 banks, accounting for about one-third of the banking system.

During the banking crisis, the BNB increased liquidity injections to support the weakening banking sector. It attempted to sterilise liquidity through open market operations and support the exchange rate via interventions on the foreign exchange market. The overall result was, however, not successful: the open market operations resulted in interest rate hikes that aggravated the servicing of the domestic debt, while the foreign exchange interventions depleted the scarce foreign exchange reserves.

The escalating political turmoil in late 1996/early 1997 and a rising budget deficit made monetary control impossible. Faced with plummeting tax revenues and escalating debt service costs, and in order to avoid default on the domestic debt, the growing budget financing needs were met with central bank credit. The monetisation of the deficit, a rapidly depreciating currency and growing political unrest stimulated inflationary expectations, and by March 1997 inflation had soared to an annualised rate of over 2000%.

Under these circumstances, a consensus developed that another money-based stabilisation attempt would be equally unsuccessful and that stabilisation would need simple disciplinary rules and a fixed exchange rate to cure the problems of soft budget constraints related to commercial bank financing and the lack of fiscal discipline. Indeed, the subsequent change in
political leadership, the introduction of the currency board arrangement (CBA) in July 1997, and the following implementation of sound macroeconomic and structural policies succeeded in restoring confidence, lowering inflation and resuming growth.

Under the CBA, the Issue Department of the BNB is allowed to hold only foreign (not domestic) assets, and is committed to buying and selling foreign or domestic currency at the 32 Bulgaria fixed exchange rate. As a result, the BNB is no longer able to control the money supply, and the supply of domestic currency is now determined by demand at the existing exchange rate. The implication for the fiscal authorities is that the deficit can be financed only through external borrowing or the sale of state assets, which obviously entails more fiscal discipline and leads to a strengthening of the fiscal position.

As for commercial banks, they are no longer refinanced by the BNB in the event of a liquidity crisis. However, the BNB still has access to IMF funding for the possible extension of a loan to the Ministry of Finance, and still has a Banking Department with a limited refinancing facility, which can be used in case of an emergency or systemic risk. Finally, it was decided that the government should hold the majority of its accounts with the BNB rather than with commercial banks, thereby reducing the volatility of the monetary base when IMF tranches are received or foreign debt payments are made.

Since the introduction of the currency board in July 1997, money supply growth has been linked mainly to balance of payments movements and inflation has dropped sharply, reflecting also the revised expectations of agents. Progress in macroeconomic stabilisation has been considerable under the currency board. In the first two years, its foreign reserves doubled, and there have been clear benefits in terms of greater transparency of economic policy. In particular, the achievements on the fiscal consolidation front have been impressive, with sizeable reductions in interest payments eventually leading to a budget surplus.

From Financial Sectors in EU Accession Countries, Editor: Christian Thimann, Published by: European Central Bank, July 2002