BULGARIA: FULLY COMMITED TO THE CURRENCY BOARD

C O N F I D E N T I A L SECTION 01 OF 02 SOFIA 000731

SIPDIS

E.O. 12958: DECL: 11/17/2018
TAGS: ECON EFIN PGOV BU
SUBJECT: BULGARIA: FULLY COMMITED TO THE CURRENCY BOARD

REF: SOFIA 679

Classified By: Ambassador Nancy McEldowney for reasons 1.4 (b) and (d)



1. (C) Summary: Bulgaria remains fully commited to the
currency board and has no exit strategy from the CB
arrangement besides Euro adoption. If the board comes under
pressure, officials here expect to see a process of
market-driven euroization rather than a move away from the
fixed exchange rate. While such a move would cause
consternation within the European Central Bank, the
Bulgarians believe choosing such a course would be better
than the instability caused by a forced move to a floating
exchange rate. The Bulgarians remain confident their policy
of fiscal conservatism will provide sufficient buffers to
survive the financial crisis. End Summary.

BANKING SECTOR STRONG; FDI AND GROWTH DOWN
--------------


2. (C) In a series of meetings with Treasury and Embassy
representatives November 17, Bulgarian Central Bank and
Ministry of Finance officials reiterated the country's strong
commitment to the currency board and stressed cautious
optimism about their chances to weather the current global
financial crisis without major upheaval. The mostly
foreign-owned banking sector continues to post impressive
profits, which parent banks have pledged to continue to
reinvest in Bulgaria for now. Capital adequacy ratio is at
14.6 percent, well above EU averages, while the
loan-to-deposit ratio is 123 percent. Non-performing loans
remain low at 2.03 percent. Because interbank lending
remains tight, some officials, such as the head of the
Deposit Guarantee Fund, are suggesting the introduction of
interbank lending guarantees and the lowering of reserve
requirements (now at 12 percent),but the Central Bank has
not yet determined if such measures will be necessary.


3. (C) Forecasters do expect a significant impact on the
real economy in terms of reduced FDI and lower growth
(reftel). FDI, which reached more than six billion euros in
2007, is down by one billion euros year-on-year for the first
nine months of 2008, largely due to a slow-down in investment
in construction and real estate. The Bulgarians hope that
reduced FDI will eventually narrow the country's high current
account deficit (expected to be 24 percent of GDP in 2008).
To compensate for expected reductions in private investment,
the GOB plans to invest 7.6 percent of GDP of next year's
consolidated budget in large public infrastructure projects.


No CB Exit Strategy
--------------


4. (C) The Bulgarians say the currency board arrangement,
put in place after a catastrophic banking crisis in 1997, has
served them well. The currency board has large buffers,
including 14 billion euros in foreign exchange reserves and
six billion euros in fiscal reserves, which could help it
withstand a hypothetical run on the lev. Our Bulgarian
interlocutors ruled out the adoption of a floating exchange
rate in the event of a more prolonged speculative attack on
the board. The only exit strategy in place is the adoption
of the euro -- currently a sensitive topic. In 2006-2007,
the Bulgarians pushed hard to join ERM-II as soon as
possible. Bulgaria managed to meet four of five criteria for
membership (persistent high inflation kept them out) and they
were urging a more lenient attitude on the part of the ECB on
these criteria. Talks with the ECB on ERM-II membership
broke down unexpectedly in December 2007, according to Khalin
Hristov, adviser to the Central Bank Governor. Bulgaria has
now been instructed by the ECB not to attach a date on ERM-II
or Eurozone membership, which has caused much anxiety within
the halls of the Bulgarian Central Bank. "We don't trust
them anymore," advisor Hristov said of the ECB.


5. (C) According to Hristov and the head of UnicreditBulBank
Levon Hampartzoumian, if the currency board comes under
sustained outside attack, Bulgaria would likely choose
market-driven euroization over a move to a floating exchange
rate. With 55 percent of deposits, 47 percent of mortgages
and 70 percent of corporate loans already euro-denomiated,
the euro is already increasingly becoming the currency of
choice. Euroization would go against EU rules, but our
contacts say Bulgaria would see this as the lesser of two
evils if it had to choose between "saving the economy" and
following ECB rules. Bulgaria hopes the current financial
crisis will make the ECB realize it has more to gain than
lose from allowing early euro adoption. Echoing this

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sentiment, Deputy Finance Minister Lubomir Datsov predicted
that talks on ERM-II for Bulgaria would resume in the next
few months, hopefully with increased flexibility on the side
of the ECB.
McEldowney