Extreme Monetary Regime Change: Evidence from Currency Board Introduction in Bulgaria
Nenovsky, Nikolay, Rizopoulos, Yorgos, Journal of Economic Issues
The introduction of the Currency Board in Bulgaria in July 1997 may be viewed as an extreme institutional change of the monetary regime and as its discrete interruption. Bulgaria switched from a regime of discretionary and subjective money supply management and floating exchange rate to an extremely passive and static form of monetary rule. Indeed, under the Currency Board regime the monetary base is covered 100 percent and above with foreign reserves, the exchange rate is fixed by law, and no monetary policy is carried out. There is an automatically balancing mechanism according to which the dynamics of the monetary base (and indirectly of the money supply) follow the dynamics of the country's balance of payments. (1)
The Currency Board in Bulgaria was introduced after the dramatic financial crisis at the close of 1996 and the beginning of 1997, when the national currency completely lost its major functions, almost one third of the banks failed, the foreign exchange reserves were almost entirely depleted, and inflation reached 240 percent in February 1997. (2) The financial crisis was accompanied by social protests and a political crisis, which led to the dissolution of Parliament and to early elections (two years prior to term). On February 17, 1997, the major political forces signed an agreement for the introduction of a currency board. The elections in April were won by a right-wing party, and the currency board was introduced on July 1.
Institutionally, the Bulgarian Currency Board differs from its orthodox forms, which are typical of the colonial system. It retains some possibilities for discretion (such as changing the minimum reserve requirement) and intervention in events of systemic risk (such as a restricted lender-of-last-resort function). Organizationally, the Bulgarian National Bank was divided into two departments, with the first one (Issue Department) comprising the most liquid assets and liabilities, and in effect performing the role of a currency board, and the second (Banking Department) retaining certain discretionary functions. The two departments are linked by the means of the Banking Department's deposit in the liability of the Issue Department, which is the net value of the Currency Board and allows for refinancing of banks in cases of systemic crisis (see table 1). (3) A third department was also established-the Banking Supervision Department-which imposes much more stringent (compared with international norms) requirements for the bank capital adequacy and bank liquidity ratios.
The analysis of currency board introduction in Bulgaria may serve as a starting point for a number of theoretical and empirical conclusions on institutional change in general and in transition economies in particular.
First, monetary regime change has been rarely analyzed using the instruments of institutional economics and political economy (generally it is treated conventionally within the framework of mainstream macroeconomic theory). (4) Considering monetary regime change as institutional change provides opportunity for seeking common ground between monetary theory and institutional analysis.
Second, although the need to incorporate institutions in the study of the transition process has been increasingly discussed, this has not been done so far in the realm of money where, generally, the paradigm of neoclassical economics is transferred mechanically. (5) Indeed, the few empirical studies of the role of institutions in transition economies (Havrylyshyn and Rooden 2000; Raiser, Di Tommaso, and Weeks 2001) have not incorporated any variable for monetary regime. Furthermore, the monetary regime change is related to one of the most essential problems of post-socialism-the overcoming of soft budget constraints. (6) Soft budget constraints in transition economies are genetic (inherited from the administrated economy) and systemic (encompassing to a different extent the relations among all agents). …