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Cahier de recherche THE NONORTHODOX CURRENCY BOARDS: THE CASE OF BULGARIA Nikolay NENOVSKY* and Kalin HRISTOV* 2001-01 January 2001

*

Bulgarian National Bank, Research Department; University of National and World Economy, Department of Finance, Sofia, Bulgaria.

Copyright © 2001. Centre d’études en administration internationale (CETAI), École des Hautes Études commerciales (HEC-Montréal). Reproduction of this paper is forbidden without the author's written authorization. École des Hautes Études Commerciales benefits from a subvention granted by the Fonds pour la Formation de Chercheurs et l'Aide à la Recherche (FCAR) for the publication of its research papers.

ISSN 0825-5822 Legal deposit – 1st quarter 2001 National Library of Canada Bibliothèque nationale du Québec

THE NONORTHODOX CURRENCY BOARDS: THE CASE OF BULGARIA

Abstract

In recent years a number of countries have introduced currency boards (CB). The new generation currency boards, which is gaining swing and popularity, preserves to different degrees the central bank's ability to perform the lender of last resort function (LOLR) and leaves room for intervention in case of systemic risk. Central bank flexibility was preserved in different forms in HongKong, Argentina, Estonia, Lithuania and Bulgaria. Macroeconomic and microeconomic implications of such departures from orthodox currency boards have not been thoroughly studied yet. In actual fact, construction of second generation currency boards (often called quasi CB) provides an opportunity for conducting monetary policy (certainly not in its typical form). The major questions that need answers are: (1) which are the new channels of monetary policy; (2) does an orthodox self-regulating mechanism work with second generation currency boards; (3) how are disequilibria in the economy adjusted? The theoretical hypotheses presented are checked empirically based on Bulgarian data.

Résumé

Ces dernières années, un certain nombre de pays ont mis sur pied des caisses d'émission. Cette nouvelle génération de caisses d'émission, en plein essor, préserve à différents degrés le rôle de la banque centrale en tant que prêteur de dernier recours et laisse une certaine marge de manœuvre en cas de risque systémique. La flexibilité de la banque centrale a été maintenue sous différentes formes à Hong Kong, en Argentine, en Estonie, en Lituanie et en Bulgarie. On n'a pas encore examiné à fond les implications macroéconomiques et microéconomiques de cette divergence par rapport aux caisses d'émission orthodoxes. En fait, la mise en place des caisses d'émission de seconde génération (souvent appelées en anglais les « quasi CB » – pour currency board) donne l'occasion de conduire une politique monétaire (qui diffère bien sûr du modèle typique). Les principales questions qui se posent sont les suivantes : 1) Quelle est la nouvelle filière de la politique monétaire ?; 2) Est-ce qu'un mécanisme d'autoréglementation orthodoxe convient à des caisses d'émission de seconde génération ?; 3) Comment corriger les instabilités dans l'économie ? Les hypothèses théoriques formulées sont vérifiées de façon empirique à la lumière de données sur la Bulgarie.

CETAI, HEC-Montréal

i

Cahier de recherche 2001-01

THE NONORTHODOX CURRENCY BOARDS: THE CASE OF BULGARIA

Tables of Contents 1.

INTRODUCTION ..........................................................................................................................1

2.

THE MAIN CHANNELS OF MONETARY POLICY UNDER THE QUASI CURRENCY BOARD ......2 2.1 Traditional channels......................................................................................................3 2.2 New channels..................................................................................................................3 2.3 The structure of the balance sheet of the Bulgarian quasi currency board .............5

3.

THE AUTOMATIC MECHANISM OF THE CB NOT FUNCTIONING ............................................6 3.1 Monetary policy through government deposit............................................................6 3.2 Does the government deposit contribute to the stabilization of the automatic mechanism? ...........................................................................................9

4.

THE MODEL AND DISCUSSION OF RESULTS ...........................................................................11 4.1 Background model.......................................................................................................11 4.2 Statistical data and econometric testing of the model ..............................................13

5.

CONCLUSIONS AND POLICY IMPLICATIONS...........................................................................15

BIBLIOGRAPHY .....................................................................................................................................17


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THE NONORTHODOX CURRENCY BOARDS: THE CASE OF BULGARIA1

1.

Introduction

Experience with stabilization programs has shown that money supply concerns are first and foremost institutional. Consequently in recent years a number of countries have introduced currency boards (hereinafter referred to as CBs) and constrained their central bank functions, reducing them to note issuing and banking supervision. A number of recent studies suggest that countries with a currency board have been quite successful in bringing down inflation. For instance, Ghosh et al. (2000) conclude that currency boards have been instituted to gain credibility following periods of high inflation, and in this regard, have been remarkably successful. Countries with currency boards experienced lower inflation and higher growth compared to both floating regimes and simple pegs. The lack of discretionary powers of a currency board is considered to be crucial in this respect.2 An orthodox currency board (we would rather call it first generation CB), typical of the colonial system, rejects monetary policy (K. Shuler, 1992; A. Schwartz 1993). It entails real economy flexibility and balance of payments liberalization. CB automation is backed by a simple and clear rule that determines the relationship between balance of payments, money supply and interest rate dynamics (Hanke S., Shuler K. 1994, Williamson, 1995). A central bank with a possibility for de facto discretionary intervention does not exist. The second, new generation currency board, which is gaining swing and popularity, preserves to different degrees the central bank's ability to perform the lender of last resort function (LOLR) and leaves room for intervention in case of systemic risk. Central bank flexibility was preserved in different forms in HongKong, Argentina, Estonia, Lithuania and Bulgaria (S. Tsang, 1999; G. Caprio, M. Dooley, D. Leipziger, C. Walsh, 1996; A. Bennet, 1993; W. Camard, 1996; J. Miller, 1999). Macroeconomic and microeconomic implications of such departures from an orthodox currency board design have not been thoroughly studied yet. In actual fact, construction of second generation CB

1

2

The views expressed in this paper are those of the authors and not necessarily those of Bulgarian National Bank. Schuler (1999) argues that "Bitter experience has taught many countries that chasing after short-term 'flexibility' in monetary policy reduces the prospects for long-term growth. There are times when you must accept losses in the short term to make greater gains later. HongKong has one of the world's best long-term records of economic growth. The currency board system has contributed to it, by enabling HongKong to avoid the currency disasters that have beset its neighbours. If central banking were to be worthwhile for HongKong, monetary policy with a domestic central bank would have to be better than the policy HongKong imports from the US Federal Reserve System. It is unlikely that HongKong would succeed where so many others have failed. The answer is rather to make the currency board system more orthodox so that the HongKong dollar becomes truly as good as the US dollar, and enjoys the same level of credibility."


1


The Nonorthodox Currency Boards: The Case of Bulgaria

(often called quasi CB) provides an opportunity for conducting monetary policy (certainly not in its typical form).3 The major questions that need answers are: (1) which are the new channels of monetary policy; (2) does an orthodox self-regulating mechanism work with second generation CBs; (3) how are disequilibria in the economy adjusted? The theoretical hypotheses presented are checked empirically based on Bulgarian data. With the introduction of a CB arrangement on 1 July 1997 Bulgaria's central bank underwent the most profound institutional change since its establishment in 1879. This radical step came in response to the severe banking and currency crisis of late 1996 and early 1997, culminating in hyperinflation in early 1997 (43% in January and 240% in February), drastic depletion of foreign currency reserves (to a critical level of USD 440 million without monetary gold), the closure of 14 commercial banks (comprising 25% of the consolidated bank balance sheet), and fully disrupted functions of the national currency (OECD, 1999). Although this study is based on the Bulgarian experience under a currency board arrangement, some of our theses are confirmed by the operation of this monetary regime in other countries. The first three years of currency board operation in Bulgaria enable us to draw some theoretical and empirical conclusions. This paper is organized in the following manner. The second section presents two major channels of conducting monetary policy: the first is inherited from former discretionary central bank policy, and the second is specific to currency board arrangement channels of monetary policy. Next we focus on the specific design of the Bulgarian currency board and discuss hypotheses of major monetary policy channels. The third section deals with departures from the automatic CB mechanism and the possibilities for conducting monetary policy in Bulgaria. The fourth section presents a theoretical model of the relationship between balance of payments, reserve money, government deposit and an econometric test based on co-integration analysis. Finally conclusions are drawn and some policy implications for the Bulgarian currency board are suggested.

2.

The Main Channels of Monetary Policy under the Quasi Currency Board

In contrast to the first generation currency boards with the new generation the possibility of conducting monetary policy is preserved. By monetary policy we mean that which intentionally affects money supply dynamics. We divide monetary policy into two types: classical, and new type conducted within the monetary regime of a currency board. The first type is associated with functions inherited from the classical central bank and the second is determined by the specific design of the currency boards.

3

A short review of the critiques against currency boards as a stabilization tool is presented in N. Roubini (1998). A comprehensive discussion on the advantages and disadvantages of the currency board as a monetary regime is made in N. Leviatan, ed. (1992).


2



2.1

Traditional channels

While orthodox currency boards precede historically independent central banks in colonial countries, the new generation CBs follow just the opposite course of development: they emerged chronologically after central banks and the discretionary monetary policy pursued by them. The latter contributes especially to the preservation of certain classical central bank tools. In most countries minimum required reserves were preserved to different degrees. In Bulgaria and Estonia minimum required reserves are set in the standard way, while Argentina has so-called liquidity requirements: commercial banks are required to hold a portion of their reserves in high-liquid U.S. securities (Banco Central de la Republica Argentina, 2000). This leaves room for central bank manipulation of reserve money and money supply through changes in the reporting methodology for commercial bank minimum required reserves and in the level of the reserves. This tool is used quite sparingly though, despite existing opportunities. In the rare cases when this tool is employed it is mainly to respond to a bank crisis triggered by external shocks, rather than as an instrument of exerting discretionary impact on money supply. The Argentine experience during the Mexican crisis is indicative of the role minimum required reserves could play under a currency board arrangement (G. Caprio, M. Dooley, D. Leipziger and C. Walsh, 1996). In Bulgaria the level of minimum required reserves was set at 11% of the commercial bank deposit based upon CB introduction and has not been modified till June 2000, despite the country's exposure to adverse external shocks related to the Russian financial crisis and the war in Kosovo. In April 1998 the methodology of reporting minimum required reserves was modified to provide for greater commercial bank autonomy and flexibility in liquidity management. Since July 2000 the Bulgarian National Bank has decreased minimum reserves requirements from 11% to 8%. This decision represents the central bank's strategic long-run policy of gradual reduction of reserve requirements to the existing euroarea level. At the same time the decision was taken in order to offset the shock generated by the Ministry of finance's policy of centralizing government money with the central bank (establishing a single account with the central bank). The second function that was preserved under the quasi currency boards is the lender of last resort, LOLR (M. Bordo, 1989). LOLR is performed within the framework of the currency board monetary rule, i.e. up to the level of central bank excess reserves. Under an orthodox currency board the net worth of reserves is used to serve only as a guarantee against assets value volatility. Retention of the LOLR function within the framework of a second generation currency board reflects a widely held view that in case of systemic banking liquidity crises public supply of liquidity is the only effective way of overcoming bank and/or currency panic (W. Bagehot, 1866; D. Diamond and P. Dybvig, 1983; X. Freixas et al., 1999).

2.2

New channels

Emergence of new monetary policy channels under new generation currency boards is determined by the choice of liabilities that need to be backed by a reserve currency and the degree of their backing. With first generation currency boards they are backed at least 100%, and the assets to back CB liabilities are issued by nonresidents. Departure from this principle under the current version of currency boards provides possibilities for the pursuit of discretionary monetary policy. The Argentine


3



model of a quasi currency board is indicative of the possibility of conducting monetary policy through establishing a certain limit for liability backing with international assets issued by nonresidents: not less than 66.6%. Within the remaining percentage the central bank of Argentina may hold securities issued by the Argentine government. Inclusion of government fiscal reserves in the liability side of a currency board (i.e. covering them with international reserves) is the major channel of monetary policy transmission in the Bulgarian model of CB. Therefore income and expense policies impact directly reserve money and money supply. In addition privatization revenues, which are a main part of foreign direct investment inflows into the country, go directly into government deposits with the central bank. This mechanism creates a kind of automatic sterilization of foreign direct investment inflows as far as the central bank is obliged by law to invest its reserves in securities issued by nonresidents (in case those privatization revenues are not used to finance government expenditure). In other words, the government may conduct, intentionally or not, discretionary (or spontaneous) monetary policy. This mechanism destroys the automatic link between balance of payments dynamics and reserve money dynamics. In these circumstances money market disequilibria do not disappear with interest rate adjustment, as they do under an orthodox CB, but rather require management of government reserves at the CB balance sheet. This way Government is capable of executing discretion, integrating fiscal and monetary policies into a syncretic whole (N. Nenovsky, K. Hristov, 1998). It is well known fact that Treasury departments' activities affect the deposits held with central banks and therefore the liquidity situation in the countries. Extensive research has been conducted to explore treasury activity impacts on liquidity conditions and on central bank monetary policies (M. Griffiths, and D. Winters, 1995; J. Hamilton, 1997; S. Almuina, 1999, among others). The main difference under the currency board is that since central banks do not conduct any kind of monetary policy operations, treasury activities create asymmetric liquidity shocks, which could not be offset by the central bank. For instance, B. Petrov (2000) concludes that treasury operations are the most significant source of shocks to interbank interest rates. He states that the specific design of the Bulgarian currency board amplifies these shocks as long as the government keeps its reserves with the central bank. Major arguments in favor of including government reserves in the liability side of the currency board balance sheet are that free movement of capital and high capital mobility cause heavy capital flow volatility, which reflects directly on reserve money and interest rates, as they are automatically linked to the balance of payments. In these circumstances government fiscal policy approximated with fiscal reserve dynamics in the balance sheet of the currency board may offset shocks and help smooth reserve money and interest rate fluctuations. In addition, it is argued that for countries like Bulgaria that have a huge external debt and large annual service obligations, inclusion of government reserves in the liabilities side and their backing with international reserves helps enhance quasi currency board credibility. At the same time, such design reduces reserve money volatility as large payments on external debt are accommodated by government reserves (J. Miller, 1999). In the next section we focus on the new channels of monetary policy to highlight how the structure of currency board liabilities reflects on the operation of the automatic mechanism: balance of payments – reserve money – interest rate. We examine this relationship on the basis of the Bulgarian design of the currency board.


4



2.3

The structure of the balance sheet of the Bulgarian quasi currency board

The central bank of Bulgaria is divided into two departments – an Issue Department and a Banking Department.4 The balance sheet of the Issue Department, which in practice plays the role of a currency board, includes international assets, which serve as cover for its liabilities. The latter is comprised of items typical of an orthodox currency board: banknotes and coins, and items typical of second generation currency boards-commercial bank reserves, government fiscal reserves and net worth expressed by the deposit of the Banking Department. The item recording the net worth of the currency board also exists in an orthodox variant but in this case it only plays the role of a buffer which absorbs shocks triggered by asset operations. With new generation currency boards the net worth expressed through the Banking Department deposit, besides the role of a buffer, also provides an opportunity for exercising the lender of last resort function within the size of the deposit in case of a systemic banking crisis. The BNB may extend loans in levs to banks through the Banking Department in the event of a liquidity risk affecting the stability of the banking system, but only to solvent banks experiencing an acute need of liquidity that cannot be provided from other sources. Such loans could be extended only against collateral of liquid assets and with a loan repayment term that must not exceed three months. BNB's Regulation N6 defines liquidity risk as a situation where the amount of the ordered but unpaid payment documents in the Banking Integrated System for Electronic Transfer (BISERA) exceeds 15% of their total amount for each of the last two days. In addition liquidity risk for the banking system is a condition under which an individual bank delays, or establishes that it is going to delay, the settlement of the payment documents submitted to it for more than three days, and the bank has at least an eight percent share of all interbank payments for each of the last five business days prior to filing a request for a loan with the BNB (BNB, 1999). The Banking Department deposit provides the link between the Issue Department and the Banking Department and also reflects the relationship between Government and the central bank (currency board). The relationship between Government and the International Monetary Fund (IMF) passes through the central bank, and tranches received in the balance sheet of the Banking Department are recorded as Borrowings from the IMF under liabilities and as a Banking Department deposit with the Issue Department under assets. Within 30 days of receipt IMF tranches are transferred to the government account whereby the Banking Department deposit decreases and the government deposit increases by the same amount. In the balance sheet of the Banking Department this transformation is recorded by crediting the deposit at the Issue Department and debiting the central bank lending to the government item. When Government does not utilize borrowings from the IMF they stay within the Banking Department deposit, thus providing larger funds for the currency board lender of last resort function.

4

This follows the model of the Bank of England, likewise divided into Issue Department and Banking Department. Bank of Estonia has a similar structure. Unlike the BNB and Bank of Estonia, the Issue Department of the Bank of England does not hold foreign exchange as a backing for the note issue, but rather domestic securities.


5



Table 1 Issue Department Balance Sheet Assets Cash and nostro accounts in foreign currency Monetary gold Foreign securities

Liabilities Currency in circulation Bank deposits and current accounts Government deposits and accounts Banking Department deposit

Table 2 Banking Department Balance Sheet Assets Nonmonetary gold and other precious metals Investment in securities Loans and advances to banks Claims on government Bulgarian's IMF quota and holdings in other international financial institutions Deposit with Issue Department

3.

Liabilities Borrowings from IMF Liabilities to other IFIs5 Capital Reserves Retained profit

The Automatic Mechanism of the CB Not Functioning

In the context of the Bulgarian currency board the two major channels of monetary policy transmission are in place: through the government affecting reserve money and through the interest rate (N. Nenovsky, K. Hristov, 1998). Jeffrey Miller was the first to state clearly some significant deviations from the automatic mechanism in operation at the Bulgarian currency board (J. Miller, 1999). He notes the fact that the balance of payments deficit does not cause automatic contraction in reserve money (see Chart 1). In our opinion, this deviation from orthodox principles is mainly due to the specific design of the Bulgarian currency board, described in the preceding section.

3.1

Monetary policy through government deposit

The orthodox CB precludes monetary policy and represents a specific form of monetary constitution. As the asset side of the balance sheet of the Issue Department does not include domestic assets, reserve money dynamics depend only on changes in foreign currency reserves: a resultant value of the balance of payments position. As is well known from experience with stabilization programs based on fixed exchange rates, the responsibility for macroeconomic management rests entirely with fiscal policy.6

5 6

IFI (International financial institutions). I. Moras (1998) constructed a CB model in which fiscal dynamics and "adverse tax shock" affect the credib,ility of the exchange rate fix. In this model budgetary policy has an indirect effect on the CB.


6



Chart 1 Changes in reserve money and balance of payments

Mln. Leva

600 400 200 0 -200 -400 97:07

98:01

98:07

99:01

99:07

Government deposit

00:01

00:07

Reserve Money

The design of the Bulgarian currency board entails (intentionally or not) the possibility for government to conduct monetary policy through its deposit with the liability side of Issue department. It can definitely be argued that there exists a specific transmission mechanism through which budgetary policy affects directly money supply and interest rates. An illustration of a simplified currency board (Issue Department) balance sheet is presented below: Table 3 Issue Department Balance Sheet Assets Liabilities F C R G B Where F – Issue Department foreign currency reserves C – Banknotes and coins in circulation R – Required reserves and excess reserves of commercial banks G – Government deposit B – Banking Department deposit (net worth of the currency board)


7



Let H be reserve money, then

H ≡ C + R ≡ F −G − B

(1)

The government deposit shows government budget revenue and expenditure and lending to Government. Let T be tax income, E government operating and investment expenditure, P receipts from privatization, dBn the value of securities financing (net) and dI the value of tranches from IMF and other IMFs (net), then the government deposit is equal to:7

G = T − E + (− P − dBn − dI )

(2)

Thus money supply assumes the classical form:

M s = mH = m[F − (T − E − P − dBn − dI ) − B ]

(3)

Where m is the money multiplier (m>0). Or:

M s = mH = m[F − T + E + P + dBn + dI − B ]

(4)

Dependent variables showing money supply response (ceteris paribus) to increases in foreign exchange reserves, tax income, Fund tranches, government spending and the Banking Department residual are as follows:

∂M s ∂M s ∂M s ∂M s > ∂M s > ∂M s > ∂M s > 0, < 0, > 0, 0, 0, 0,

(ρ FGσ F − ρ BGσ B )

(11)

σH

As the correlation between currency board assets and the government deposit, ρFG is a positive value, the correlation between the Banking Department deposit and the government deposit, ρBG is negative, the mean square deviations of CB assets, the Banking Department deposit and reserve money are positive figures, then the term on the right side of inequality (10) is positive as a whole. Therefore the correlation between reserve money and the government deposit should be at best positive or:

0 < ρ HG ≤ 1

(12)

Inequality (12) imposes a strict condition on the behavior of the deposit and reserve money: they need always move in the same direction. If their one-way dynamics is broken, it may be argued that the government deposit has a disturbing and destabilizing effect on the reserve money supply.

4.

The Model and Discussion of Results

4.1

Background model

The theoretical model is aimed at checking two hypotheses. The first is whether the automatic connection between reserve money dynamics and balance of payments dynamics typical of orthodox currency boards is valid for second generation CBs. The second task is to find out how inclusions of fiscal reserves in the liabilities of the quasi CB affects reserve money dynamics and the money market adjustment process.9

9

There is one more issue concerning effectiveness of currency boards operation. It is the question, to what extent the interest rate performs its function of a transmission mechanism for money market adjustment to various external and internal shocks? We do not explore that issue, as B. Petrov (2000) has conducted research for Bulgaria on this topic.


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With first generation currency boards (orthodox CBs) reserve money dynamics is determined entirely by balance of payments dynamics. If there are no possibilities of changing the level of reserve money backing by international reserves and the level of commercial bank minimum required reserves (if any), there are no factors causing deviations from the long-run relationship between reserve money and balance of payments. This means that for a long-run cointegration relationship between reserve money and balance of payments to be in place, i.e. to be cointegrated with cointegration vector CI (1,1), reserve money and the balance of payments should be nonstationary. The factors providing for the possibility of deviation from the long-run relationship between reserve money and balance of payments are retention of the lender of last resort function and the possibility of a change in the level of minimum required reserves as well as the methodology of their reporting under a currency board. Inclusion of government fiscal reserves in the liabilities of the currency board is the other major source of impulses for deviation from the classical relationship between reserve money and balance of payments. The third possibility is to have capital inflows, which are not reflected in the financial account of balance of payment as far as they are not induced by market forces. This could be IMF financing and other sort of official financing, which is based not on a market decision, but mainly on political concerns. The theoretical model of cointegration between reserve money and balance of payments is applied to the Bulgarian case. In the period under review the BNB did not perform its LOLR function and did not change the level of commercial bank minimum required reserves. Under these conditions the only source determining the deviation of reserve money dynamics from balance of payments dynamics are government fiscal reserves which destroy the long-run relationship between the two variables. Econometric cointegration and error correction methodology are widely used in studies exploring long run equilibrium among variables. (Campbell, J., P. Perron, 1991; Enders,W., 1995). A principal feature of cointegrated variables is that their time paths are influenced by the extent of any deviation from long-run equilibrium. After all, if the system is to return to the long-run equilibrium, the movements of at least some of the variables must respond to the magnitude of the disequilibrium. The first stage of this methodology is the unit root test for the following variables: h t = log (H t ) – logarithm of reserve money bop t = log (BOP t ) – logarithm of balance of payments g t = log (G t ) – logarithm of government deposit The second stage involves measuring the long-run and short-run relationship between reserve money and foreign currency reserves determined by balance of payment dynamics. The cointegration relation (i.e. the long-run relationship) between reserve money and the balance of payments is shown below:

ht = α 0 + α1bopt + ε t Where εt is the stationary disturbance term.


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The mechanism of error correction (i.e. short-run balancing dynamics) is as follows:

∆ht = A(L )∆ht −1 + B(L )∆bopt −1 + C (L )∆g t −1 + δ (ht −1 − α1bopt −1 − α 0 ) + β 0 + υ t A(L), B(L) and C(L) are lag polynomials and δ is the correction coefficient of restoring long-run equilibrium. Under a well functioning automatic CB mechanism the coefficient is α 1 = 1, i.e. the increase or decrease in reserve money is equal to the increase or decrease in foreign currency reserves.

4.2

Statistical data and econometric testing of the model

The present study covers the period following the introduction of the currency board in Bulgaria. Monthly data from BNB monetary statistics for the period July 1997-September 2000 are used. The following variables are used: reserve money (H), fiscal reserves (G), and balance of payments performance (BOP). All series are transformed in logarithm. The first two variables are taken from Issue Department monthly balance sheets. Reserve money is calculated as a sum total of banknotes and coins in circulation and commercial bank reserves, recorded in the Issue Department balance sheet. As monthly data on the balance of payments capture flows, we transformed this data into stock using June 1997 as a starting point. In order to capture the effect of reserve requirements reduction in the middle of 2000 we create a dummy and use it as an exogenous variable. We do not report this dummy in the results because it is insignificant. Since cointegration analysis10 is applicable only to nonstationary time series with levels, we apply the unit root test to the variables used (h, bop, g). We apply the ADF test, and obtain the results displayed in Table 6. Table 6 Unit Root Test McKinnon Critical Values a (ADF)

Augmented Dickey-Fuller Test Variables First Levels differences H -2.96 -4.65 Bop -2.60 -3.80 G -2.74 -4.87 a) Critical values refer to the case with constant without trend.

1% -4.22 -3.61 -4.22 and trend

5% -3.53 -2.94 -3.53 except for

10%

Order of Integration and Lags Integration

-3.19 I(1) -2.60 I(1) -3.19 I(1) balance of payment, which is

Lags 2 1 1 constant

The variables h, bop and g are I(1). This enables us to apply the Johansen test for cointegration between reserve money (h) and balance of payments (bop). The econometric testing proved the

10

We used the E-Views 3.1 software for econometric testing.


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existence of a cointegration vector (no linear deterministic trend (or?) intercept, and no trend in the cointegration equation). Drawing on the understanding that government fiscal reserves in the balance sheet of the quasi CB are the only source of reserve money deviation from balance of payments movements, we construct two Vector Error Correction (VEC) models. In the first we include reserve money and the balance of payments and examine the short-run dynamics between the two variables. In the second model government fiscal reserves are included as an endogenous variable. The results are summarized in Table 7. Table 7 Cointegration and Vector Error Correction Model 1 Model 2 Variables* Dependent variable h Dependent variable h Co – integration equation ( long run relationship) -17.606 Intercept -9.56 (-3.64) 0.20 0.26 Bop (0.59) ( 1.80) Vector Error Correction (short run relationship) -0.14 -0.31 Error correction term (-2.95) (- 2.44) -0.25 -0.08 D(h (-1)) (1.59) (-0.44) -0.40 -0.22 D(h (-2)) (-2.69) (-1.40) -0.02 0.01 D(bop (-1)) (-0.46) (0.25) 0.10 0.06 D(bop (-2)) (1.65) (-1.90) 0.18 D(g (-1)) (2.46) R2 0.29 0.33 2 R adjusted 0.20 0.22 Log likelihood 53.52 54.66 F statistics 3.28 3.10 * t values in parentheses.

The results from the two models may be summarized as follows. First, expected unity of α1 is not confirmed, in model 1 the coefficient is α 1 = 0.20, and in model 2 the coefficient is α 1 = 0.26, which, despite the expected positive sign is well below unity. These values confirm our hypothesis of a broken parallel dynamics of reserve money and balance of payments. The source of this deviation is explained by the fact that the deficit in the balance of payments is neither entirely financed by a


14



change in the reserve money of the currency board, nor by credits from the IMF and other international financial institutions. At the same time capital inflow which is entered in the balance of payments capital account, does not directly affect reserve money as the predominant amount of this capital are receipts from privatization deals accumulating in the government deposit (fiscal reserves). In both models the error correction term is statistically significant. In the first model the coefficient representing speed of adjustment is quite low. Including government deposit as an exogenous variable improves this coefficient significantly, making restoration of long-run equilibrium faster. The characteristics of model 2 are much better due to inclusion of the government deposit in the short-run dynamics. This confirms our hypothesis that fiscal reserve movements have a keybalancing role for the operation of the currency board in Bulgaria.

5.

Conclusions and Policy Implications

The suggested theoretical model and the empirical analysis of the operation of the Bulgarian currency board give grounds for the following theoretical conclusions. (1)

The Bulgarian currency board is a hybrid of an orthodox currency board and a classical central bank. It combines a lack of flexibility typical of first generation CBs with elements of central bank flexibility. Critics of the currency board's lack of flexibility are not referring to the Bulgarian type of currency board. There are options for conducting monetary policy, and the LOLR function is preserved in combination with additional new channels to affect the reserve money supply through the specific design of the currency board balance sheet. This provides room for a rapid response to banking and currency crises.

(2)

The automatic adjustment mechanism of the orthodox currency board does not function: the reserve money supply does not follow balance of payments dynamics. Nevertheless, there exists a long-run cointegration relation between the two variables. Short-run equilibrium is made possible through budget flows (expenditure, revenue, privatization, securities floating and tranches from the IMF and other IFIs).

(3)

The presence of government fiscal reserves in the form of a deposit in the liabilities on the Issue Department balance sheet not only provides an opportunity for discretionary manipulation of the reserve money supply but also, as already noted, has a destabilizing rather than a stabilizing effect. For this deposit's presence to have a stabilizing impact on reserve money, its correlation with reserve money needs be at best positive, a condition that cannot always be fulfilled.

(4)

The hybrid form of the CB in Bulgaria is not desirable. There are several possible alternatives for a change in the Bulgarian CB. The first is to go back to a first generation CB and restore the classical automatic adjustment mechanism. This requires shifting the government deposit from the Issue Department balance sheet to one of the several options available: commercial banks, a separate institution, a combination of these two options or placing government money with the Banking department balance sheet. This measure should be accompanied by


15



elimination of minimum required reserves or shifting to liquidity requirements as in Argentina. The second alternative is to move closer to a discretionary central bank by active and deliberate management of the government deposit with a view to affecting the reserve money supply (i.e. reserve money will be targeted similarly to a classical central bank) upon assessment of money demand. The third alternative is going beyond an orthodox currency board solution by adopting the Euro as a parallel currency, and later as the official currency unit in Bulgaria, namely because of the problems with the automatic mechanism of the currently operating CB. These alternatives should be carefully considered. In our opinion, however, the first alternative: restoration of the classical CB, or the last one: adoption of the Euro as legal tender, appear to be most appropriate in the case of Bulgaria. Any attempt at conducting intentional discretionary policy in whatever form would be doomed to failure, and may even be detrimental to the existing operation of the current CB.


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Bibliography ALMUINA, S. "Location of Government Deposits: Implications for Monetary Operations", IMF MAE Operational Paper, MAE OP/99/2, 1999. BAGEHOT, W. What a Panic is and How it Might be Mitigated, The Economist, XXIV, 12 May 1966, 554-555, in M. Collins (ed.), Central Banking in History, Cambridge, The Economist, Vol. I, 1966, p. 236-237 BANCO CENTRAL DE LA REPUBLICA ARGENTINA. Main Features of the Regulatory Framework of the Argentine Financial System, April 2000. BULGARIAN NATIONAL BANK. Banking Laws and Regulations, Sofia, 1999. BENNETT, A. "The Operation of the Estonian Currency Board", IMF Staff Papers, Vol. 40, No. 2, 1993, p. 451-470. BENNETT, A. Currency Boards: Issue and Experiences, in Frameworks for Monetary Stability. Policy Issues and Country Experiences, IMF Washington, 1994. BORDO, M. "The Lender of Last Resort: Some Historical Insights", NBER Working Paper 3011, 1989. CAMARD, W. "Discretion with Rules? Lessons from the Currency Board Arrangement in Lithuania", IMF Paper on Policy Analysis and Assessment, 96/1, 1996. CAMPBELL, J.; PERRON, P. "Pitfalls and Opportunities: What Macroeconomists Should Know About Unit Roots", NBER Technical Working Paper N100, 1991. CAPRIO, G.; DOOLEY, M.; LEIPZIGER, D.; WALSH, C. "Lender of Last Resort Function Under a Currency Board. The Case of Argentina", World Bank Working Paper 1648, 1996. DIAMOND, D.; DYBVIG, P. "Bank Runs, Deposits Insurance, and Liquidity", Journal of Political Economy, Vol. 91, Issue 3, 1983, p. 401-419. ENDERS, W. Applied Econometric Time Series, John Wiley & Sons, Inc., 1995. FREIXAS, X.; GIANNINI, C.; HOGGARTH, G.; SOUSSA, F. "Lender of Last Resort: A Review of Literature", Bank of England Financial Stability Review, Issue 7, 1999, p. 151-167 GHOSH, A.; GULDE, A.-M.; WOLF, H. "Currency Boards: More than a Quick Fix?", Economic Policy, Vol. 15, Issue 31, 2000, p. 269-335 GRIFFITHS, M.D.; WINTERS, D.B. "Day of the Week Effects in Federal Funds Rates: Further Empirical Findings", Journal of Banking and Finance, 1995, p. 1265-1284. HAMILTON, J. "Measuring the Liquidity Effect", The American Economic Review, Vol. 87, No. 1, 1997, p. 80-97.


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HANKE, S.; SCHULER, K. Currency Boards for Developing Countries: A Handbook, (An International Center for Economic Growth Publications), San Francisco, California, ICS Press, 1994. LEVIATAN, N. (ed.). Proceedings of a Conference on Currency Substitution and Currency Boards, Washington D.C., The World Bank, 1992. MILLER, J. "The Currency Board in Bulgaria: The First Two Years", Bulgarian National Bank Discussion Paper, DP/11/99, 1999. MORAS, I. "Exchange Rate Based Inflation Stabilization with a Currency Board, European University Institute, Department of Economics, August 1998. NENOVSKY, N.; HRISTOV, N. "Financial Repression and Credit Rationing under Currency Board Arrangement for Bulgaria", Bulgarian National Bank Discussion Paper, DP/2/98, 1998. ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT. Economic Survey of Bulgaria, OECD, Paris, 1999. PETROV, B. "Bank Reserves Dynamics under Currency Board in Bulgaria, Bulgarian National Bank Discussion Paper, DP/15/00, 2000. ROUBINI, N. The Case Against Currency Boards: Debunking 10 Myths about the Benefits of Currency Boards, 1998 [http://www.stern.nyu.edu/~nroubini/asia]. SCHULER, K. Currency Boards, Dissertation, Fairfax, Virginia, George Mason University, 1992. SCHULER, K. "The Importance of Being Orthodox", Hong-Kong Baptist University's International Workshop on Currency Boards, HongKong, 9 October 1999. SCHWARTZ, A. "Currency Boards: Their Past, Present and Possible Future Role", Carnegie-Rochester Conference Series on Public Policy 39, 1993, p. 147-187. TSANG, S. A Study of the Linked Exchange Rate System and Policy Options for HongKong, HongKong Policy Research Institute Ltd., 1999. WILLIAMSON, J. What Role Currency Boards, Washington, D.C., Institute for International Economics, 1995.


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