By Mihalis Sarris
The euro, a symbol of European unity and economic integration, will soon welcome Bulgaria into its fold. Bulgaria, which has been a “partial” member since the introduction of the Monetary Board, is on the brink of full membership in the eurozone.
But history has shown that meeting the Maastricht criteria alone is not enough to reap the benefits of euro zone membership: countries must navigate a complex landscape of fiscal discipline, structural reforms and monetary policy devolution.
The incomplete initial structure of the euro area
The creation of the eurozone brought about a close economic union, but its structure was far from perfect. Its framework relied on an independent central bank to maintain macroeconomic and price stability and imposed strict fiscal rules. But the eurozone lacked provisions for fiscal transfers to troubled countries, crisis management mechanisms, and EU-wide financial oversight. Its designers assumed that misconduct would come only from the public sector, and ignored potential financial imbalances and bank overexpansion in the private sector. This deficiency in oversight made the eurozone vulnerable to the crises it was designed to prevent.
The onset of the euro crisis
Capital flowed from wealthy eurozone countries to developing emerging economies, much of it into unproductive sectors such as real estate, creating real estate bubbles. This flow was channelled through local banking systems and affected countries such as Ireland, Spain, Portugal, Greece and Cyprus.
The 2008 crisis revealed the flaws in this system.
With the exception of Greece, fiscal mismanagement was not the main cause of imbalances: Ireland's debt-to-GDP ratio at the time was just 25%, for example, similar to Bulgaria's current situation.
Peripheral member states enjoyed low borrowing costs and access to foreign exchange, which led them to neglect necessary structural reforms and limited their ability to adapt to economic shocks.
As the real estate sector collapsed, a vicious cycle was created: banks took on excessive risks and came close to bankruptcy, while over-indebted governments were unable to provide support, causing government bonds to fall in value and damaging bank portfolios. Post-crisis reforms have aimed to break this destructive cycle.
Response to the Euro Crisis
Despite the lack of pre-designed crisis management mechanisms and major failures such as the Deauville Accord in 2010 and the Cyprus bail-in in 2013, the euro has shown remarkable resilience. Coordinated responses have included:
– European Stability Mechanism.
– ECB full monetary transactions and quantitative easing.
– Mario Draghi promised to “do whatever it takes” to save the euro.
While fiscal expansion mitigated the decline in economic activity, it also led to a sharp increase in public debt. This, combined with austerity-led policies, especially in Greece, led to severe economic difficulties.
A New Approach: The COVID-19 Crisis
The COVID-19 pandemic led to a major shift in economic policy. The EU suspended the Stability and Growth Pact and introduced the Next Generation EU Recovery Programme financed by co-borrowing, and the ECB launched a €2 trillion pandemic emergency purchase programme. These measures led to a re-evaluation of macroeconomic policy, central bank independence and the relationship between monetary and fiscal policy. Unlike the 2010 crisis, the 2020 response included a sustained fiscal stimulus funded by central bank purchases of government bonds.
Towards a fiscal and banking union
The challenge of avoiding public debt and the taboo against central banks financing budget deficits has led to reforms of fiscal rules, allowing greater flexibility for countercyclical measures and large investment programmes to address climate change and other supranational objectives. At the same time, efforts to complete the banking union are gaining momentum, with a focus on risk sharing, harmonisation of insolvency laws and the provision of reliable financial support.
The way forward for Bulgaria
As Bulgaria prepares to join the euro area, Prime Minister Denkov stressed the importance of preparing Bulgaria to handle asymmetric financial and real shocks on its own, given the current incompleteness of the banking and fiscal union. Bulgaria must:
– Accelerating structural reforms to improve competitiveness and growth.
– Strengthen governance and invest in quality education.
– Promote flexible wage and cost structures to compensate for slowing productivity growth.
– Maintain fiscal discipline.
With the support of the Single Supervisory Mechanism, Bulgaria needs to improve risk management in its banking system, monitor rapid credit growth in its banks, and strengthen its macroprudential framework and banking supervision. If these challenges are managed successfully, Bulgaria has a bright future in the euro area.
Conclusion
In conclusion, Bulgaria's integration into the euro area is not just a milestone, but a journey that requires careful preparation, strong reforms, and a willingness to navigate economic complexities. With the right steps taken, Bulgaria can look forward to a prosperous and stable future within the euro area.
Mihalis Sarris is a former World Bank Executive Director and served as Cyprus' Minister of Finance from 2005 to 2008 and in 2013. This article is based on remarks made at a conference on the euro in Bulgaria, organised by the Bulgarian Association in Sofia on 14 May 2024. It has also been featured on the blogs of Banks, CFA and Honorary Consuls. This article has also been featured on the Cyprus Economic Association Blog.
