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Wiiw Research Report 265: Fiscal Policy Under a Currency Board Arrangement

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Wiiw Research Report 265: Fiscal Policy Under a Currency Board Arrangement WIIW Research Reports No. 265 March 2000 Rumen Dobrinsky Fiscal Policy Under a Currency Board Arrangement: Bulgaria's Post-crisis Policy Dilemmas Rumen Dobrinsky Fiscal Policy Under a Rumen Dobrinsky is Economic Affairs Currency Board Officer, United Nations Economic Arrangement: Commission for Europe/Economic Analysis Division. The author has longstanding Bulgaria's Post-crisis research relations with WIIW. Policy Dilemmas Contents Abstract...............................................................................................................................i Executive Summary........................................................................................................... iii 1 Introduction ...................................................................................................................1 2 Fiscal policy in a currency board system .......................................................................2 3 Some issues in transitional fiscal accounting.................................................................6 4 Bulgaria’s recent economic performance.....................................................................11 4.1 Post-crisis adjustment..........................................................................................11 4.2 Competitiveness ..................................................................................................13 4.3 The state of the enterprise sector.........................................................................17 5 Current fiscal policy dilemmas .....................................................................................20 6 Concluding remarks ....................................................................................................26 References .......................................................................................................................29 Tables and Figures ...........................................................................................................30 Appendix: Restructuring Intrinsic Loss-Makers (ILMs): some fiscal implications ................41 List of Tables and Figures Table 1 Bulgaria: Selected macroeconomic indicators................................................30 Table 2 Consolidated general government fiscal account (% of GDP)........................31 Table 3 Profits and losses in the Bulgarian corporate sector.......................................32 Table 4 Average profitability of sales in the state sector of the economy by branches, % ..............................................................................................33 Table 5 Flows of enterprise arrears to the state budget and flows of enterprise interest arrears, % of GDP................................................34 Figure 1 Consolidated government account: non-interest and interest expenditure, % of GDP.......................................................................................................35 Figure 2 Public debt, % of GDP ...................................................................................35 Figure 3 Indices of aggregate output and gross fixed investment, 1989 = 100.............36 Figure 4 Employment and unemployment....................................................................36 Figure 5 Labour productivity in industry and investment ratio, indices, 1989 = 100 ......37 Figure 6 Indices of real wages in industry, 1989=100...................................................37 Figure 7 Indices of the real exchange rate, 1989=100..................................................38 Figure 8 Indices of relative labour productivity (total economy = 1), 1989 = 100...........38 Figure 9 Real unit labour costs in industry and export performance.............................39 Figure 10 Wage costs in industry and trade deficit .........................................................39 Abstract The paper analyses some policy issues under a currency board arrangement (CBA), focusing on the conduct of fiscal policy which is the only policy instrument at the disposal of the authorities as the CBA precludes an independent monetary policy. It is argued that the loss in degrees of freedom under a CBA restrains considerably the room for fiscal policy manoeuvre, especially in cases of external disturbances or shocks. Within this framework the paper analyses some of the policy challenges that policy makers in Bulgaria have been facing since 1997. It is argued that despite the macroeconomic stabilization and the fiscal consolidation achieved after the introduction of the CBA, some serious economic problems still remain and new ones have emerged; among them are the deterioration in competitiveness and the large losses that SOEs continue to generate. The paper addresses also some more general issues related to fiscal accounting during the transition in the context of the intertemporal budget constraint of the public sector. Attention is drawn to the importance of monitoring not only the conventional fiscal balance but also the broader fiscal balance, including the quasi-fiscal deficit. Keywords: Bulgaria, macroeconomic regime, currency board, fiscal policy, fiscal accounting, public sector solvency JEL classification numbers: E62, E63, P52 i Executive summary The difficult transition from plan to market in Bulgaria was marked by persistent macroeconomic and financial instability leading to a major economic collapse in 1996-97. In 1997 a currency board arrangement (CBA) was established as a 'policy of last resort' to reverse macroeconomic instability and to impose fiscal and financial discipline. The experience since the introduction of the CBA has been mixed, combining notable progress in macroeconomic and financial stabilization with sluggish economic activity, rising unemployment and deteriorating external balances. In addition, the CBA implies a substantial loss of sovereignty in economic policy. This paper argues that this consequence is not only confined to the area of monetary policy (which is eliminated altogether) but extends to fiscal policy, strictly reducing the functions of the latter to sustaining the long-term solvency of the public sector. The resulting loss in the degrees of freedom considerably restrains the room for policy manoeuvre, especially in cases of external disturbances or shocks. The paper addresses also some more general issues related to fiscal accounting during the transition in the context of the intertemporal budget constraint of the public sector. Attention is drawn to the importance of monitoring not only the conventional fiscal balance but also the broader fiscal balance, including the quasi-fiscal operations of the central bank and the deferred contingent fiscal liabilities of the government. In particular, it is argued that the losses generated by state-owned enterprises (SOEs) should be considered in the broader definition of the fiscal balance of the public sector as these losses are the primary ingredients of the quasi-fiscal deficit. The smooth functioning of a CBA implies a high degree of price and wage flexibility for the economy to be able to accommodate external disturbances. However, Bulgaria's economic performance since the introduction of the CBA has revealed a low degree of responsiveness of the labour market, and, in particular, a high degree of inertia in wage setting. The absence of well-functioning shock absorbers has instigated a substantial deterioration in competitiveness which, in turn, has resulted in the opening of large external imbalances. The paper analyses some of Bulgaria’s post-crisis policy challenges. It is argued that despite the macroeconomic stabilization and the fiscal consolidation achieved after the introduction of the CBA, some serious economic problems still remain and new ones have emerged; among them are the deterioration in competitiveness and the large losses that SOEs continue to generate. The available policy options to address these problems under a CBA are limited: one of the conclusions is that due to the reduced degrees of policy freedom in the context of the current macroeconomic regime, fiscal policy is very restricted in what it can do to counterbalance the mounting quasi-fiscal deficit, the loss in competitiveness and the escalating external imbalance. iii Rumen Dobrinsky* Fiscal Policy Under a Currency Board Arrangement: Bulgaria’s Post-crisis Policy Dilemmas 1 Introduction Throughout the 1990s Bulgarian macroeconomic policy has been facing numerous challenges resulting from the unprecedented transformational recession, large and persistent macroeconomic imbalances – some inherited from the previous regime and others emerging subsequently – and, more generally, from the overall fragility of the economy. The need for a massive reallocation of resources and the hardship this entailed for the population were persistent and severe constraints on the degrees of freedom open to policy makers. The implementation of efficient policy was also hampered in the beginning by the lack of wide public support for the reform process and by a general deficiency of experience and skills in the conduct of macroeconomic policy. In general, the Bulgarian transition has been very difficult, with considerable delays in the introduction of some reforms and a series of setbacks in economic performance. In 1996-97 Bulgaria experienced a major 'triple' crisis comprising a currency crash, a run on the banking system and a drain on the public finances, the result being an outburst of hyperinflation and the closure
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