Bulgaria faces an additional challenge on the path to the euro zone

"The secret criteria for our membership in ERM 2 is the Banking Union," Bulgarian Prime Minister Boyko Borissov said in mid-April.

The government led by Mr Borissov sees the Banking Union requirement, which is not an official precondition for ERM 2 entry, as an attempt to postpone Bulgaria's membership of the euro zone. In order to prevent such a delay, the finance minister will send a letter of intent and will expect a firm commitment that Bulgaria will be allowed to enter ERM 2 on the day it joins the Banking Union, sources within the government explain.

"We must make sure that the commitments made to us are firm, because we do not want to enter a game without an end, which we now see in the case of Schengen," said Mr Goranov.

While Bulgaria officially meets the criteria to become part of Schengen - the EU's borderless area, since 2011, several member states have been blocking the country's admission, saying the weakness of its law enforcement system could jeopardize the security of other countries.

The initial push

The earlier probes into a possible admission into ERM 2 were quite promising, several government sources claim. While Bulgaria was preparing its six-month presidency of the Council of the EU that started on January 1, government officials were canvassing the opinions of member states for several months. In June 2017, Mr Borissov left hurriedly the European Council meeting in Brussels for Berlin to meet the then German Finance Minister Wolfgang Schaeuble, who, according to people present at the meeting, encouraged Bulgaria to apply to ERM 2.

However, Bulgaria had the wind knocked out of its sails quickly. On several occasions ECB officials attempted to discourage Bulgaria from applying to join the euro zone. While this opposition was never officially stated, it could be read between the lines of various public documents and speeches.

Take for example the interpretation of Bulgaria's readiness to join the Euro zone, an assessment which the ECB and the European Commission give in their convergence reports that were both published on May 23. Although the language and recommendations are practically identical to those found in the 2016 reports, now both institutions give a much more negative evaluation of the recurring findings on the need for reforms, not only in the financial sphere, but also in justice and education. They reports read that Bulgaria doesn't meet all convergence criteria for joining the euro zone, although the only formal criterion it doesn't meet is the two-year period each candidate must spend in ERM 2.

Later, French President Emmanuel Macron, who initially publicly encouraged Bulgaria, suggested that the country has to join the Banking Union first. His position is backed by representatives of other euro zone member states. There was a certain degree of disagreement even within the European Commission, which generally has supported Bulgaria. Its Vice President Valdis Dombrovskis reiterated once again on May 23 that Bulgaria meets the nominal criteria for membership in the euro zone, while Economic and Financial Affairs Commissioner Pierre Moscovici on several occasions urged caution.

The barrage of negative comments surprised the Bulgarian government, which probably had mistaken the initial polite encouragement for firm support. In response, the chair of the national parliament's budget committee, Menda Stoyanova, said that if Bulgaria is rebuffed, it will mean that the country is being treated unfairly and that double standards are its applied in the case of its application.

It is difficult to say, however, if more intensive lobbying could have helped.

Why is there so much opposition?

Finance Minister Vladislav Goranov has long kept silence about the government's intentions regarding Bulgaria's accession to the euro zone. Negotiations with the ECB are a delicate matter and it should not look like the country is trying to force its way through the door of the club. If Bulgaria's efforts to enter ERM 2 had remained confidential, the potential negative reaction in some of the countries in the euro area could have been mitigated more easily.

The delicacy of the negotiations is reinforced by the fact that admission into ERM 2 for Bulgaria would practically mean a rapid entry into the euro area.

The idea of ERM 2 is to stress-test the candidate country's ability to maintain financial discipline and the stability of the exchange rate of its currency against the euro. For Bulgaria, which fulfills the nominal membership criteria on inflation, long-term interest rates, level of public debt, and budget deficit, and for 20 years now has been operating a fixed exchange rate of its lev currency - first to the German mark and then to the euro, this is more of a formality. If the analogy with the waiting room is extended, the bigger obstacle is the front door to ERM 2, because once a country is inside, it is not as difficult for it to enter the living room and relax on the couch.

Representatives of the ECB no longer hide that this is the main reason for their resistance to let Bulgaria enter ERM 2. They, as well as some euro zone member states, fear that once admitted into the club Bulgaria will abandon its fiscal discipline and will go on a spending spree - just like Greece and Italy did. This danger was clearly spelled out by Commissioner Moscovici in April: "Looking at Greece, they didn't have enough time to prepare, joined the euro area unprepared and this led to a crisis. Bulgaria must join with a strong economy. Convergence is fundamental. It must have strong institutions and be part of the banking union."

The ball is in Bulgaria's field

The ECB's demand to have Bulgaria into the Banking Union first is not so much an excuse for delaying the country's entry into ERM 2, but rather a tool to pressure on the government and the Bulgarian National Bank (BNB) to finally tackle the weaknesses in the country's banking sector. The problems with several banks that need recapitalization (or some other type of resolution) are well known and have been underlined by the European Commission.

In order for Bulgaria to enter the Banking Union, the ECB will need to conduct an in-depth assessment of the banks it will oversee. Currently, these would be UniCredit Bulbank, DSK Bank and United Bulgarian Bank - the three biggest lenders in terms of assets in Bulgaria, but the ECB may decide to apply it to other institutions as well.

In the course of this audit, there is a high probability of detecting more serious irregularities than those already identified by the BNB in its own asset quality review (AQR) of 2016. And if the ECB concludes that there is a need for bank restructuring, the costs will have to be borne entirely by the Bulgarian budget. This is the main reason why the BNB and the finance ministry did not want to apply for membership in the Banking Union before Bulgaria has joined the euro zone.

That said, the ECB will probably encourage Bulgaria to fix the problems in its financial sector first. This will take time and may further delay the country's entry into the Banking Union and ERM 2.