Sofia University „St. Kliment Ohridski“ Faculty of Economics and Business Administration Department: „Industrial Economics and Management“

ANALYSIS OF CONVERGENCE IN THE ECONOMIC AND MONETARY UNION

Seventh Annual Academic Contest "Dr. Ivanka Petkova" Prepared by: Magdalena Vlahova-Veleva

SOFIA 2018

Contents List of figures ______2 List of tables ______2 Abbreviations ______2 1. Introduction ______3 2. Relevance of the subject ______3 3. Research question ______3 4. Research methodology ______3 5. Economic and Monetary Union ______4 6. Maastricht criteria ______4 7. Advantages and disadvantages of adopting the ______6 8. Overview of the criteria ______6 9. ______12 10. VAR model ______15 11. Conclusion ______18 References ______19

1

List of figures Figure 1 Maastricht Criteria - ...... 7 Figure 2 Balance and Debt- EU-28, 2017 ...... 9 Figure 3 EMU criterion and debt ...... 9 Figure 4 Debt and deficit clusters, 2016 ...... 10 Figure 5 HICP ...... 11 Figure 6 Corrplot ...... 12 Figure 7 EU, EA, Bulgaria ...... 14 Figure 8 Bulgaria, and Greece ...... 15 Figure 9 Impulse response function ...... 17 List of tables Table 1 Maastricht Criteria ...... 5 Table 2 Criteria – EU overview ...... 7 Table 3 Criteria overview and member states ...... 8 Table 4 ERM II and introducing the euro ...... 10 Table 5 Correlation ...... 12

Abbreviations BDIF Bulgarian Deposit Insurance Fund EA Euro area EC ECB EMU Economic and Monetary Union ERM II Exchange Rate Mechanism II ESCB European System of Central Banks ESM European Stability Mechanism EU European Union GDP Gross Domestic Product HICP Harmonised Indices of Consumer Prices VAR Vector AutoRegression model

2

1. Introduction The analysis examines the interaction between the macroeconomic indicators of the European Union member states and the dynamics of the government securities as well as the other convergence criteria. The report begins with an introduction of the concept of Economic and Monetary Union in Europe. Followed by a presentation of the Maastricht convergence criteria, which each Member State of the European Union should meet in order to join the . An overview of the values of these criteria is made: price stability, sound and sustainable public finances, exchange rate stability, long-term interest rates for the period 2006-2017. Data on Bulgaria and their compliance with the benchmarks are considered.

2. Relevance of the subject The relevance of the subject of the report is determined by the diverse concepts of deepening the economic and monetary union (EMU). The reinforcement of EMU remains one of the European Commission's key priorities for restoring a strong and stable European financial system since the start of the global financial crisis in 2008. Currently, there is an ongoing work on strengthening the structure of EMU, allowing a faster and more resolute response to future challenges. Various initiatives on this subject were presented on 6 December 2017. In 2018, they are expected to be considered and tangible steps in this direction are expected to be taken. The overall objective is to improve the unity, efficiency and democratic accountability of the Economic and Monetary Union in Europe by 2025. The meeting held on 12 July 2018 presented a roadmap for the accession of Bulgaria and any future candidate country to the Eurozone. Furthermore, the concept of convergence is of particular importance in the context of the European Union and the euro area. A key idea of the project are the so-called Maastricht criteria and whether the Member States cover them. Applying the relevant reference values for Bulgaria also strengthens the importance of the chosen topic, due to the fact that the country is targeting a recent adoption of the single European currency - the euro. Full membership in the European Union also implies joining the Eurozone when the country meets the relevant criteria. The need for sound economic policies, however, does not end with the adoption of the euro. The dynamic events in Europe over the past few decades have put the issue of completing EMU, creating new institutions and rules on the agenda.

3. Research question The analysis studies the degree of meeting the Maastricht criteria, if members states or groups of countries are compliant or not, and to which appertains Bulgaria. Moreover, the study analyses the relationshiops between the four convergence criteria.

4. Research methodology The research methodology in the report is based on generally accepted research methods, which are characteristic of the realization of reasoned results. In addition, the research question was explored by applying econometric methods. Statistical information is processed through software products: Microsoft Excel and R Studio. The interrelations between the indicators are analyzed. A VAR model is used to investigate the linear dynamic interdependencies of the variables. The empirical model

3 examines whether inflation, budget deficit and government debt have any explanatory effects on long-term interest rates (yield on government securities) in member states.

5. Economic and Monetary Union Currently, 28 countries are part of the European Union (EU), with some consolidating their integration by adopting a single European currency - the euro. This latter is called the Eurozone, consisting of 19 Member States1. As members of the EU, the other nine countries have committed to introducing the euro (with the exception of and the UK, the EU Treaties foresee "opt-out" clauses for them2) and are called "member states with a derogation". The Economic and Monetary Union (EMU) draws in a common monetary policy, the coordination of economic and fiscal policies and the euro – the common currency. Initially, the euro was introduced as an accounting currency for cash payments in 1999 and in 2002 as real banknotes and coins. According to Eun and Resnick (2012), the euro must be seen as a product of historical development towards the ever-deepening integration of Europe, beginning with the creation of the European Economic Community in 1958. The euro was founded with the aim of reviving European countries and to achieve closer economic integration leading to faster economic growth and guaranteeing a peaceful Europe (Stiglitz, 2016). The first ten years of EMU creation are characterized by low inflation and moderate economic growth (Papademos, 2008). Participation in EMU is considered a common insurance condition for all its members (European Commission, 2008). All countries must meet the same criteria and be assessed in the same way - "the principle of equal treatment" (Stark, 2008).

6. Maastricht criteria To join the euro area, EU Member States need to comply with the convergence criteria laid down in the Maastricht Treaty3 of 1992. These economic and legal conditions ensure that the individual member state is ready to join the euro area, without creating risks for the economy of the country itself, but also for the euro area as a whole. In order to monitor the process of convergence of economic dynamics in the member states related to the (EMS), the European Commission and the European Central Bank monitor the Maastricht criteria (Gerunov, 2016). These convergence criteria have the following economic purposes: price stability, sound and sustainable public finances, exchange rate stability and long-term interest rates. There is also a legal convergence whereby the candidate country must ensure that its national laws regulate the independence of the central bank and its statutes are in line with the provisions of the Treaties and is compatible with the Statute of the ECB and the ESCB. The convergence criteria are listed in table 1.

1 www.ec.europa.eu; These 19 countries are Austria, Belgium, Germany, Greece, Estonia, Ireland, Spain, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, Finland, France. 2 The other non-euro area countries are: Bulgaria, , , , , and . 3 Council of the European Communities, Commission of the European Communities, „Treaty on European Union“, (1992) 4

Table 1 Maastricht Criteria Economic objective Indicator Criteria Sound and sustainable public Government debt < 60% of GDP finances Budget deficit < 3% of GDP < 1.5% above the three best Price stability HICP performing Member States < 2% above the rate of the Long-term interest three best performing Member Durability of the convergence rates States in terms of price stability Participation in the Exchange Deviation from a Rate Mechanism (ERM II) for Exchange-rate stability certain level at least two years without severe tensions Source: Gerunov, (2016) Under the EU Treaty, the bonds used to calculate the convergence criterion relating to long - term interest rates should be long - term government bonds or similar securities with a maturity of 10 years. Daniel and Shiamptanis (2008) show that countries with debt-to-GDP ratios well above the Maastricht Treaty reference value are likely to face fiscal risks, and vice versa in countries with relatively low government debt in percent of GDP it is less likely to observe fiscal risks. According to Polasek and Amplatz (2003), interest rates follow a tighter path of convergence than inflation, due to the market pressure of a common currency and both are under the control of the monetary authorities, while the deficit variables are substantially less stable and their convergence path is more volatile compared to the target. The Exchange Rate Mechanism was first introduced in 1979 as a means to curtail exchange rate variability and to attain monetary stability, before the adoption of the euro. After the introduction of the single currency in Europe, the Exchange Rate Mechanism II (ERM II) was set up and its purpose is to link the currencies of member states outside the Eurozone to the euro as a central point. It represents a way of evaluation and preparation for potential members of the euro area. At the moment, only Denmark takes part in ERM II with a fluctuation band of +/- 2.25%, while the official fluctuation margin is +/- 15%. As defined in article 140 of the Treaty on the Functioning of the European Union the Commission and the European Central Bank shall report the fulfillment the convergence criteria by the Member States. This examination is done at least once every two years or at the request of a Member State with a derogation. The conclusions of the latest convergence reports (2018) of EC4 and ECB5 are that Bulgaria presently fulfils three of the convergence criteria, those linked to price stability, public finances and long-term interest rates. The forth criterion for participating in the ERM II is not fulfilled. However, the country has targeted to join the mechanism in July 2019.

4Covergence Report 2018, European Commission, Institutional paper 078, www.ec.europa.eu, (2018) 5Convergence Report 2018, European Central Bank, www.ecb.europa.eu, (2018) 5

7. Advantages and disadvantages of adopting the euro There are various advantages of countries sharing a single currency. Some of the obvious positives are the lower transaction and administrative costs and price transparency, as everything is priced in the same currency. The euro allows for a free and easy movement of goods, capital and labor within the euro area, it permits also an integration of economic activities from different countries (Mursa, 2014). Usually, when accessing the euro area credit rating of the country is being increased, so long term interest rates tend to be lower. The single currency provides greater certainty for business organisations and encourages inward investments. The euro implies a greater presence for the Union in the global economy. Being part of the euro area gives member states the possibility to access the common Eurozone funds and instruments, such as the European Investment Stabilisation Function (the eligible criteria would be decided in the end of 2018), the European Stability Mechanism (ESM), etc. Although the single currency provides many advantages, it also has some disadvantages. One of them is the centralisation of decision making, there is a common monetary policy. Moreover, there are costs of introducing a single currency. Every member state makes contributions to the ECB, to the ESM as well, according to specific contribution keys based on the total population and gross domestic product of the country. Of course, more pros and cons could be envisaged depending on the particular country case. But in general, when put together the benefits of a common currency in Europe are exceeding the disadvantages.

8. Overview of the criteria The four convergence criteria for the European Union are presented in figure 1. As depicted in the graphs, there was a significant volatility in price developments due to the economic crisis. Inflation„s peak was in 2008 – 3.7%, followed by a sharp decline in 2009.It raised again in 2010 and then consumer prices were diminishing until reaching 0% in 2015. The data for 2016 and 2017 shows that HICP started to increase again – 0.3% in 2016 and 1.7%in 2017. The first half of the studied period is characterised by relatively high bond yields owing to issues related to financing of debt by member states. EMU criterion6 was singnificantly higher in 2012 (3.64%) in comparison to 2017 (1.31%). The EU„s government deficit-to-GDP ratio had its highest value of -6.6% 2009 – a year after the crisis. Thereupon, the deficit started to shrink. From 2016 to 2017 the deficit decreased by 0.6%. In 2007 the government debt-to-GDP ratio respected the reference value of 60% and was equal to 57.5%. Nevertheless, the ratio was growing considerably until 2014, reaching 86.5%. In 2017 debt dropped to 81.6%, still higher value compared to the standing rule.

6 In this report EMU criterion signifies the Maastricht criterion for long-term interest rates, as defined by Eurostat. 6

Figure 1 Maastricht Criteria - European Union

Source: Author„s graphs based on Eurostat data A period of twelve years - from 2006 to 2017 is studied. Summary results from the beginning, the middle and the end of the period are presented in table 2. Some key findings regarding the criteria overview for the EU, are that before the economic crisis the levels of debt and deficit were compliant with the respective reference values. However, after the crisis, the average debt level in EU was 68.7% of GDP and the average budget balance was - 3.8% of GDP. In 2017 both indicators are improving. In the same year the inflation mean value is decreasing, as well as the average long-term . Table 2 Criteria – EU overview 2006 2012 2017 EMU criterion Min. 3,3 1,4 0,3 Mean 4,2 5,0 1,6 Max. 7,2 22,5 6,0 HICP Min. 1,3 0,9 0,3 Mean 3,0 2,9 1,7 Max. 7,4 5,7 3,7 Debt Min. 4,4 9,7 9,0 Mean 44,9 68,7 68,2 Max. 103,6 159,6 178,6 Budget balance Min. -9,3 -10,5 -3,1 Mean -1,1 -3,8 -0,3 Max. 5,0 0,3 3,9 Source: Data collected from Eurostat

7

Table 3 reveals the member states with minimum and maximum values of the indicators for the respective years. Regarding the mean values, the countries close to the average levels, are indicated. Greece is the country with highest long-term interest rates in 2012 and 2017 and it is the most indebted member state for the whole period. At the same time, Estonia reports the lowest debt. In 2006 Bulgaria‟s EMU criterion has average value and its inflation is the highest compared to other EU member states. Denmark. Luxembourg and Malta have registered the biggest surpluses correspondingly in 2006, 2012 and 2017. In 2016 the EU Member States non-compliant both with debt and deficit criteria, are France and Spain. Nonetheless, in 2017 only Spain does not comply with the two criteria. The countries having debt levels above 100% of GDP in 2017 are Greece (178.6%), Belgium (103.1%), Italy (131.8%) and Portugal (125.7%). Some of the Member States such as Germany, Cyprus, Finland, are improving their balance compared to 2016, even so various of them continue to experience significant levels of debt. Netherlands managed to reduce the indicator from 61.8% in 2016 to 56.7% in 2017, hence, becoming compliant with the target. The budget deficit as a share of GDP in the EU is down from -1.6% in 2016 to -1% in 2017, in the Eurozone this drop is from -1.5% to -0.9%. Twelve EU Member States register a budget surplus in 2017: Bulgaria, Czech Republic, Denmark, Germany, Greece, Croatia, Cyprus, Lithuania, Luxembourg, Malta, Netherlands and Sweden, while Slovenia has a balanced budget. Spain reports a deficit exceeding the 3% rule and equal to -3.1% of GDP, while Portugal„s deficit is exactly 3% of GDP. The other Member States report a deficit which is within the reference value. (see also figure 2)

Table 3 Criteria overview and member states 2006 2012 2017 EMU criterion Min. Luxembourg Denmark Lithuania Mean Bulgaria Poland Spain Max. Romania Greece Greece HICP Min. Poland, Finland Sweden Ireland Mean Luxembourg, Portugal Luxembourg Germany Max. Bulgaria Hungary Estonia, Lithuania Debt Min. Estonia Estonia Estonia Mean Netherlands Croatia, Malta Ireland Max. Greece Greece Greece Budget balance Min. Hungary Spain Spain Mean Slovenia Poland, Romania Estonia, Ireland Max. Denmark Luxembourg Malta Source: Information interpreted from Eurostat data

8

Figure 2 Balance and Debt- EU-28, 2017

Source: Author„s calculations based on Eurostat data Linear regression equation: Budget Balance = 0.77 – 0.02Debt

Figure 3 represents the linear regression between long-term interest rates and public debt, which is expressedby the following equation: EMU criterion = 0.15 + 0.2Debt The p-value is less than 0.05, indicating the statistical significance of the model. Adjusted R- Squared is 0.26, meaning that 26% of all variations of the dependent variable can be practically explained by the model. Figure 3 EMU criterion and debt

Source: Author„s calculations based on Eurostat data On figure 4 EU member states are grouped into 3 clusters. The first one encompasses countries meeting the deficit and debt criteria, such as Estonia, Latvia, Bulgaria, Luxembourg. The second group includes countries whose debt exceeds the required maximum in 2016, including Ireland (68%), Germany (64.1%), Finland (61.4%) etc. The third cluster includes countries with debt levels well above 60%, and the one country, which fails to meet the 3% of GDP deficit criterion – Spain.

9

Figure 4 Debt and deficit clusters, 2016

Source: Author„s graph based on Eurostat data Legend: Green – compliant countries, Red – non-compliant countries, Blue – non compliant countries with high debt levels

Table 4 represents the EU member states that have recently adopt the euro. In 2015, Lithuania became the 19th country to join the euro area, after more than ten years in ERM II. Evidently, the time spent in the mechanism varies according to the specific country cases. For instance, Slovenia and Estonia entered the mechanism both in 2004, though, the first adopted the euro in 2007, while the second introduced it four years later.

Table 4 ERM II and introducing the euro ERM II Introducing the euro Lithuania 27.5.2004 1.1.2015 Estonia 27.6.2004 1.1.2011 Slovenia 27.6.2004 1.1.2007 Latvia 2.5.2005 1.1.2014 Malta 2.5.2005 1.1.2008 Cyprus 29.5.2005 1.1.2008 Slovakia 1.11.2005 1.1.2009 *The intensity of the grey color indicates the order of introducing the single currency with the darkest revealing the latest introduction. Countries are listed in the order of their accession to ERM II.

According to a survey conducted by Alfa Research Agency in Bulgaria, a common apprehension encountered among the society is a possible high rise in prices once the euro is adopted. As previously mentioned, one of the convergence criteria is exactly the inflation measured by the Harmonised indices of consumer prices (HICP). This economic indicator is

10 calculated by forming a consumer basket of around 700 goods and services7. It is a comparable measure of EU Member States consumer price change. Consequently, the HICP of the euro-area countries that have joined lately, is observed. In 2007-2008 there was an increase in the HICP, followed by a sharp drop of the indicator due to the financial and economic crisis, in some countries like Malta this period coincided with the introduction of the euro. As can be seen from figure 4, in general, inflation has slightly increased after the introduction of the single currency. Price levels have declined afterwards and have stabilized.The indicator follows a common direction and it can be said that it depends on the economic cycle. The latter is defined by Burns and Mitchell (1946) as follows: “Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own”. During the expansionary phase of the business cycle, incomes and profits are rising, leading also boosts inflation. Therefore, the acceleration of prices, for example, in Slovenia and Lithuania in 2008 could be explained by the economic downturn rather than by the introduction of the euro. Moreover, HICP has declined afterwards.

Figure 5 HICP

Source: Author„s graphs Legend: The green line is the year when the euro is introduced in the country. The red line corresponds to the financial crisis – 2008.

The relationship between the four criteria for EU and EA is examined. The correlation between government debt and the budget balance is negative and equals -0.2665 (EU) and -

7 www.ecb.europa.eu 11

0.2376 (EA), i.e. when debt is increasing, the budget balance is deteriorating and may be in deficit (table 5). The correlations between EU indicators are graphically displayed in a corrplot (table 6). Often budget deficits are the main contributor to debt, as governments sell debt instruments in order to finance deficits (Driessen, 2017). Moreover, there is a strong positive relationship between inflation and long-term interest rates of 0.7720(EU), 0.7022 (EA). Fisher„s model (1907) suggests that a change in nominal interest rate signifies an underlying movement in inflation. Additionally, the correlation between debt and interest rates is -0.5445 (EU) and -0.5229 (EA). Table 5 also indicates the strong linkage between HICP and budget balance. It could be said that inflation, budget deficit and government debt have explanatory effects on yield on government securities in the EU and the EA. The results are similar to those of Ardagna (2009), stating that 10-year nominal yields on government bonds raised significantly in the years with greater fiscal deficit for the period 1960-2002.

Table 5 Correlation EMU HICP Balance Debt EMU 1 0.77207 -0.3895 -0.6642 HICP 0.7022 1 -0.082 -0.5445 Balance -0.3819 0.0693 1 -0.2665 Debt -0.6645 -0.5229 -0.2376 1 Source: Author„s calculations Legend: Blue = EU; Red = EA Figure 6 Corrplot

Source: Author„s graph 9. Bulgaria In 2007 Bulgaria became a member state of the European Union, thus, made a commitment to join the Eurozone. For this purpose, the country has to meet all the convergence criteria, analysed below. For the studied period Bulgaria's inflation rate reached its highest value of 12% in 2008, but the following year it declined significantly to 2.5%. In 2014, 2015 and 2016 deflation is observed. Negative inflation could be risky: due to lower prices, consumers are postponing their spending as they think they will get more in the future for their money. This

12 leads to shrinking production, higher unemployment and, accordingly, it is limiting incomes. In 2017 Bulgaria meets the price stability criterion of 1.9%8, with an inflation equal to 1.2% The long-term interest rate in Bulgaria peaked in 2009 and it was 7.22%. Followed by a period of decline, reaching 2.27%. in 2016 and 1.60% in 2017. The latter is signaling the stabilized economic situation. Thus, the country is compliant with the 3.2%8 reference value of the convergence criterion for long-term interest rates. The next examined criterion for Bulgaria is the government debt, amounting to 21% in 2006, 13% in 2008, then it tends to increase and reaches 25.4% of GDP in 2017. The country meets the convergence criterion for debt throughout the studied period, with a government debt level well below the 60% of GDP reference value. Figure 5 shows that the country did not meet the deficit-to-GDP criterion (-4.1%) in 2009 caused by the economic crisis. Over the next few years, the deficit was under 3% of GDP. An exception is 2014 when the deficit is -5.5%. The doubled deficit is primarily due to the fact that the Bulgarian Deposit Insurance Fund (BDIF) is included in the general government sector in accordance with a recommendation of the EC. In the same year, the BDIF paid the guaranteed deposits of the failed Corporate Commercial Bank. This could be considered as a one-off event, the effect is temporary and does not affect the budget balance for the subsequent years. In 2017 Bulgaria reported a surplus of 0.9%. In general, the average debt-to-GDP ratios for the EU and the EA are substantially above the reference value of 60%. Furthermore, various countries do not meet the debt and deficit criteria during theperiod 2006-2017. Bulgaria became an EU member in 2007, just before the global financial and economic crisis. In general, the country maintained fiscal sustainability. The numerical criteria are key to euro area enlargement, but finally political will is determinative. Supreme decision on enlargement is taken by the Council of the EU. In the Union legislation this is called „abrogation of the derogation“. All EU member states should be confident that the specific country is compliant with the defined ciriteria and is prepared to adopt the single currency, hence, to vote for the accession of that country. To conclude, Bulgaria meets the economic criteria for convergence, except the participation in ERM II. In June 2018 the Bulgarian Minister of Finance and the Governor of the Bulgarian National Bank sent a letter to the Presidents of the Eurogroup and the Ecofin on Bulgaria‟s path towards ERM II participation. Moreover, in August 2018 an Action plan with measures related to the country„s intention to join ERM II and the Banking Union by mid- 2019, was approved.

8 European Central Bank, Convergence Report 2018 13

Figure 7 EU, EA, Bulgaria

Source: Author„s graph Legend: Red – Bulgaria; Blue – EU; Green – EA The black line corresponds to the financial crisis – 2008.

Maastricht criteria of three EU member states is being compared. Those are Bulgaria, Greece – euro area member since 2001 and Lithuania – the last country to adopt the euro in 2015. The Greek financial crisis started with the global financial crisis in 2008. The problems were compounded due to endogenous factors. Currently, the third economic adjustment programme for the country has ended. Greece received financial assistance by the European Stability Mechanism with the aim restore fiscal sustainability and financial stability. The country has committed to implement various measures and reforms to ensure sustainability of public debt. Nevertheless, Greek debt is still very high and far above the reference level of 60% of GDP, experiencing a slight decline in 2017. On the other hand, Bulgaria and Lithuania are compliant with the debt rule for the whole period of the study. The three countries experience budget surplus in 2016 and 2017 with respect to the 3% rule. The trend of the long-term interest rates is declining, hence, encouraging investment spending. Bernoth et al. (2004) stated that participating in the EMU implicates a decrease in spreads. Inflation raises in all three countries in 2008 – the peak of the crisis, with an overall decline up to 2015, followed by a slight increase. In general, respecting the established criteria is important. Bulgaria„s indicators are in line with them. Adopting the single currency in Lithuania did not cause any specific disturbances. Greece experienced a severe economic crisis and fiscal unsustainability. One possible reason for Greece not being compliant with the strict Convergence criteria when joining the Eurozone is that the country did not reported accurate data (Armitage and Chu, 2015). At the same time, various studies and analysis show that one year after adopting the single currency, euro is said to boost both business and investments, rating agencies upgrade the credit ratings of the country

14 and borrowing costs diminish, fees for cross-border transactions decrease as well (Rapoza, 2016). Maastricht criteria are set to ensure the stability of the Euro area as members„ economies are highly related.

Figure 8 Bulgaria, Lithuania and Greece

Source: Author„s graphs Legend: Red – Bulgaria; Blue – Lithuania, Green – Greece

10. VAR model Vector autoregression models were popularized by Sims (1980), who proved that VAR is a useful and flexible tool for analysis in economics. To the best of this author„s knowledge, no previous VAR model analyses the relationship between the Maastricht criteria in a similar way. The contribution intents to supplement the literature in this topic. In order to confirm whether long term interest rates are impacted by public debt, budget balance and inflation, the following assumption is considered: H1: EMU = f (Debt, Deficit, Inflation) The applied VAR model consists of four variables of the Eurozone: debt, deficit, inflation and long-term interest rates. The employed data for these four economic indicators consists of yearly observations, taken from Eurostat for the period 2006 to 2017. The level stationary of the selected variables is tested. TheAugmented Dickey-Fuller and Phillips-Perron tests are applied. The results suggested that time series are not stationary, so unit root. Thus, order one of the series is chosen in the model. VAR is computed by utilising ordinary least squares (OLS) equation. The type of deterministic regressors to include is trend.

15

The VAR model is expressed by the following equation:

xt = v + aoxt + a1xt-1 + a2xt-2 + ... + apxt-p + εt

where xt is a (K X 1) vector composed of endogenous variables and it is observed at time t=0,1,2,...,T; v is a constant, εt represents white noise processes, ai are (K X K) coefficiet matrices for i=1,...,p. In VAR all variables are analysed symetrically and for each variable there is a separate equation. The latter describes the evolution of each variable in reference to its own lags and the lags of the other variables. The equation for EMU criterion is: EMU = 0.519EMU + (-0.003)HICP + 0.022Deficit + 0.056Debt + (-0.005) The p-value of the model is significantly lower than 0.05, hence, indicating the statistical significance of the model. The high value of adjusted R-squared shows the practical significance of the model. The F-statistic is equal to 101.4. Thus, the assumption that long term interest rate is affected by changes in deficit and debt, is supported by the empirical results, but there is light impact by HICP. A theoretical model developed by Kinoshita (2006) validates that an augmentation in debt boosts the long term interest rate. Moreover, some studies show that in advanced economies fiscal variables define the bond yields (Baldacci and Kumar, 2010). The estimation results regarding HICP are the following: HICP = 0.454EMU + (-0.188)HICP + 0.029Deficit + 0.013Debt + (-0.110) The adjusted R-squared is 0.549, however, the p-value is 0.72 which is above the established reference value for statistical significance. Concerning the deficit the estimation results are as follows: Deficit = (-2.839)EMU + 0.435HICP + 0.571Deficit + 0.196Debt + (-1.217) The adjusted R-squared equals to 0.89, while the equation is considered as statistically significant with a p-value of 0.001. The equation shows that when debt increases by 1%, deficit raises by 0.196%. The debt estimation results are presented by the equation below: Debt = 7.080EMU + (-0.584)HICP + (-0.477)Deficit + 0.4523Debt + 3.214 It is statistically significant, the adjusted r-squared shows that most of the movements of the dependent variable can be explained by the model. The equation demonstrates that when the long term interest rate rises by 1%, government debt increases with 7%. Thus, Emu criterion largely impacts debt. When joining the ERM II and when adopting the euro, usually the credit rating of a country increases, leading to lower long-term interest rates. As showed above, bond yields has strong linkages with debt-to-gdp ratio and deficit. Thus, the latter indicators would further improve. Canton and Packer (1996) found that bond yields move in the expected direction subsequent to credit rating announcements.

The impulse response function of VAR analyses dynamic effects of the system when the model receives an impulse. Impulse responses are best represented in graphs displaying the responses of a VAR endogenous variable in time.

16

The response between these variables is captured on figure 6, with 95% confidence bands, boots trapped with 100 replications. Certain observations regarding the impulse response functions for the VAR model of the different series, have been made. First, the impulse response of deficit to debt, inflation and long-term interest rate, is presented. A deficit shock has a considerable impact on debt in the subsequent period. This kind of shock influences also inflation for around two periods. The effects are getting smaller and smaller in the long run. Then, impulse in inflation impacts considerably deficit and debt from period zero to the second period. Cherif and Hasanov (2012) showed that inflation shock affects debt ratio after only a few quarters. A shock in long-term interest rates has significant positive effects on debt and smaller impact on price stability and budget balance. Finally, an impulse in debt of the Eurozone is observed. The so-called EMU criterion experiences a slight, but continuous effect. Comparing the results of the model with other analysis, it is examined that similar results were stated by Engen and Hubbard (2004). They showed that and augmentation in US debt boosts 5-year Treasury bonds. At the same time HICP and deficit stabilize in several periods. The dotted lines demonstrate the 95% interval estimates of these effects.

Figure 9 Impulse response function

17

Source:Author„s calculations

11. Conclusion: Severe economic downturns, such as the economic and financial crisis in 2007-2008, may seriously affect various economic indicators. However, it is important to achieve a stable and firm recovery. Before accessing the Euro area, a member state needs to be ready, so it would not cause any economic risks for the country itself and for the entire Eurozone. What is more, the EU takes measures to strengthen the Economic and Monetary Union and to make sure that it is better prepared for future shocks. According to Eun and Resnick (2012) the completion of the third stage of EMU is forthcoming and the success of the euro can contribute to a strong impetus for Europe's political unification. Several convergence criteria are set to ensure that a member state is ready to adopt the single currency. As proved above, the criteria are highly dependent on one another. For instance, government debt and long-term interest rates are strongly linked. Thus, a member state needs to meet all of the criteria. According to convergence reports of EC and ECB of 2018, Bulgaria continues to meet the economic criteria for price stability, debt, deficit and long-term interest rates. With regard to the exchange rate stability criterion, Bulgaria is not part of the ERM II, but the is pegged to the euro at a fixed rate of 1 euro BGN 1.95583. Convergence must be achieved not only at a given time, but must be sustainable. As stated in the letter sent by Bulgaria to the Presidents of Eurogroup and the Ecofin: „Bulgaria has a good track record od more than 20 years in maintaining fiscal stability and sustainability with public deficit and debt levels wellbelow the Stability and Growth Pact tresholds...“. The analysis of the Maastricht convergence criteria shows that during the 2006-2017 period, there are some Member States whose indicators do not meet the benchmarks. In contrast, Bulgaria successfully fulfills the numerical convergence criteria.

18

References: 1. Ardagna, S., „Financial markets‟ behaviour around episodes of large changes in the fiscal stance“, European Economic Review, 53(1), pp. 37-55, (2009) 2. Armitage, J., Chu, B., „Greek debt crisis: Goldman Sachs could be sued for helpinghide debts when it joined euro“, www.independent.co.uk, (2015) 3. Auf dem Brinke, A., Enderlein, H. and Fritz-Vannahme, J., „What kind of convergence does the euro area need?“, Gütersloh: Bertelsmann Stiftung und Jacques Delors Institut – Berlin, (2015) 4. Baldacci, E. and Kumar, M., „Fiscal deficits, public debt, and sovereign bond yields“, IMF Working Papers, pp. 1-28, (2010) 5. Bernoth, K., Von Hagen, J. and Schuknecht, L., “Sovereign Risk Premia in the European Government Bond Market”, ECB Working paper 369, (2004) 6. Bondare, O., „Joining the European Monetary Union“, RGSL Research papers No 3, (2011) 7. Borsi, M., Metiu, N., „The evolution of economic convergence in the European Union“, Discussion paper, No 28, (2013) 8. Burns, A., Mitchell, W., „Measuring Business Cycles“, New York: National Bureau of Economic Research, (1946) 9. Cantor, R., Packer, F., „Determinants and impact of sovereign credit rating“, Economic Policy Review, Federal Reserve Bank of New York, Current issues in Economic and Finance, Vol. 1, No. 3, (1996) 10. Cherif, R., Hasanov, F., „Public Debt Dynamics: The Effects of Austerity, Inflation, and Growth Shocks“, IMF working paper, Institute for Capacity Development, (2012) 11. Convergence Report 2018, European Central Bank, www.ecb.europa.eu, (2018) 12. Covergence Report 2018, European Commission, Institutional paper 078, www.ec.europa.eu, (2018) 13. Council of the European Communities, Commission of the European Communities, „Treaty on European Union“, (1992) 14. Daniel, B., Shiamptanis, C., „Fiscal Risk in a Monetary Union“, University at Albany, SUNY, Department of Economics, Discussion Papers, (2008) 15. Driessen, A., Deficits and Debt: Economic Effects and Other Issues, Congressional Research Service, (2017) 16. Engen, E., Hubbard, G., “Federal Government Debts and Interest Rates.” NBER Working paper No.10681, (2004) 17. Eun. C., Resnick, B., „International Financial Management“, 6th ed., New York: The McGraw-Hill, 42-49, (2012) 18. European Commission, “EMU@10: Successes and challenges after 10 years of Economic and Monetary Union”, (2008) 19. Fisher, I., „The Rate of Interest“, New York: MacMillan Company, (1907) 20. Franks, J., Barkbu, B. et al., „Economic Convergence in the Euro Area: Coming together or drifting apart?“, IMF Working Paper, (2018) 21. Gerunov, А., „Public finance: theory and finance“, ''St. Kliment Ohridski” University Press, (2016) 22. Jorion, P., „Value at Risk, The New Benchmark for Managing Financial Risk“, 2nd Edition, McGraw-Hill, United States, (2001) 23. Kinoshita, N., „Government debt and long-term interest rates“, IMF Working Paper, WP/06/63, pp. 1-23., (2006) 24. Mursa, G., „Euro – advantages and disadvantages“, CES Working Papers, vol. 6(3), issue 3, 60-67, (2014) 25. Papademos, L., „The international role of the euro: Trends, determinants and

19

Prospects“, Brussels Economic Forum 2008, (2008) 26. Petre, A., „Trends and Challenges of Cohesion and Convergence in the European Union“, International Journal of Economic Practices and Theories, Vol. 5, No 4, (2015) 27. Polasek, W., Amplatz, C., „The Maastricht Criteria and the Euro: Has the Convergence Continued?“, Journal of Economic Integration 18 (4), 661-668, (2003) 28. Rapoza, K., „Lithuania And The Euro: One Year Later, The Romance Continues“, www.forbes.com, (2016) 29. Stark, J., “The Adoption of the Euro: Principles, Procedures and Criteria” (Speech given at the Icelandic Chamber of Commerce). Reykjavik, (2008) 30. Stiglitz, J., „The Euro“, Penguin Press, (2016) 31. „Assessment of the fulfilment of the Maastricht convergence criteria and the degree of economic alignement of the Czech Republic with the euro area“, Ministry of Finance of the Czeh Republic and the Czech National Bank, (2017) 32. www.ec.europa.eu/eurostat

20