Bulgaria’s rocky path to the euro

Bulgaria is the first country applying to join the euro area that is required to first enter the banking union. That is why it is very difficult to say how this process will unfold. The ECB was reluctant supporter of Sofia's application over concerns about weak financial supervision in Bulgaria and low level of economic and income conversion with the rest of the euro area member states. The Frankfurt-based institution could still delay its OK to enter in close cooperation (a banking union version for non-euro countries) with the Bulgarian National Bank (BNB), but not for too long. Since the political decision has already been made ECB could only require the Bulgarian authorities to meet some technical adjustments.

By joining the ERM II, the so called euro's waiting room, Bulgaria will have a clear perspective on its path to adopting the EU's single currency. The ERM II is designed to test applicants' ability to maintain price stability, but because of Bulgaria's currency board regime (Bulgaria's lev is fixed to the euro), it is more or less a formal exercise. If there is no major macroeconomic disturbance, after two years in ERM II, Sofia should be invited to become the 20th member of the euro zone. Ideally this could happen already in 2021.

"The overall evaluation of the efforts is positive but after all this is a waiting room for the waiting room," opines Georgi Angelov, senior economist at the Open Society Institute - Sofia, adding that "there has been a crack in the China wall, but the door still stays closed".

The arrangements

On July 18th the Bulgarian government sent an official letter to the ECB, applying to join the banking union. In the course of next year, both the European Commission and ECB will be overseeing the implementation of the commitments undertaken by the Bulgarian government and the Bulgarian National Bank, on which basis a decision about the country's future accession to ERM II will be taken.

The first and foremost condition for the country is to strengthen the supervision of its financial sector by joining the Single Supervisory Mechanism (SSM), i.e. the oversight of the biggest Bulgarian banks will be transferred to Frankfurt. Before that though ECB is to evaluate the state of the financial sector with its own comprehensive assessment. Given the frail status of several Bulgarian banks, it could require the Bulgarian authorities to take actions that are currently being postponed.

This was one of the main reasons why BNB and the Bulgarian ministry of finance hesitated about SSM membership. If a bank would need recapitalization or is stripped of its license, the decision will be taken in Frankfurt, but BNB and the Bulgarian budget will bear the costs. Before joining the euro Bulgaria will not have access to ECB liquidity support programs.

"ERM II is worth the price of the banking union, but BNB has the right to be cautious," former Deputy Finance Minister Lyubomir Datzov said.

Bulgaria has also promised to further develop the macroprudential framework or in other words to set more regulatory measures covering the whole system rather than certain financial institutions. So far BNB has done so through capital-based measures to which borrower-based ones will be added.

The third and very important commitment is to strengthen the supervision of the non-banking financial sector, which includes insurance companies and pension funds. Although this commitment does not point to concrete objectives, the stress tests conducted by the Bulgarian Financial Supervision Commission have revealed weaknesses in pension funds' investment practices (like related party transactions) or inadequate capitalization of insurance companies.

Bulgaria will also need to work on its insolvency framework, issues connected to money laundering and reforming its poorly-managed state-owned enterprises, which the European Commission has identified as a probable future risk for the budget.

What happens next?

It is not very clear what the ECB will be checking exactly as this is the first time a non-euro country will be entering the banking union. Analysts believe the ECB will be using its well-known methodology such as stress tests and it will be looking closely into the three biggest banks in Bulgaria - UniCredit Bulbank, DSK and UBB, as well as some of the banks which were criticized in the 2016 BNB report, FIB and Investbank.

No set date for membership can be given yet as the ECB might have several other conditions for the banks to meet beforehand but both the Bulgarian government and EU officials see the summer of 2019 as a possible time frame. However, the joint statement didn't specify an exact date when the review will wind up.

Entering the banking union might involve some additional costs but nothing major. Automatically, Bulgaria will enter the Single Resolution Mechanism (which deals with failing banks) and pay whatever has been saved up by the National Recovery and Resolution Fund (410 million levs as of June) into the EU's Single Resolution Fund. The country will also have to transfer the future contributions from the banks. Some of the banks that will be subject to ECB's supervision will have to pay audit taxes to the ECB rather than the BNB and most probably those payments will be larger than the current ones.

Worried Europe

Although this decision is not what the Bulgarian government was hoping for - a straight invitation to join the ERM II, it is still a progress, considering that application for the eurozone has been thought of by three governments. Yet, it shows how anxious Western Europe is about new entrants in the eurozone, especially amid Greece's financial crisis, and even more importantly, how worried the EU is about the inefficiency of Bulgarian institutions. Bulgaria does not carry the best reputation and is known as "the poorest and most corrupt in the EU", which makes it logical for the ECB to be cautious with its decision on Bulgaria. Although Bulgaria is the first country being considered for accession to ERM II in the last 13 years, the drawn path to the euro is no highway and has its risks.

Next year, both the ECB and the European Commission will be preparing for a change in leadership that might question the current formal agreement with Bulgaria. The joint statement by the Eurogroup and ECB is not a final decision and the text allows for wide interpretations, if there is a change of heart about Bulgaria application for the euro's waiting room. For example, the requirement for Bulgaria to "take further commitments at the moment of joining ERM II with the aim of achieving a high degree of sustainable economic convergence" could be used to prolong the two-year testing period in the euro's waiting room because there is no exact definition of the term "sustainable convergence".

In the meantime, Bulgaria has every right to be nervous about the comprehensive review of its financial system by ECB. If the aim is to prevent Sofia from entering the euro area, ECB can go "too much in depth" with the inspection and thus show a not so rosy situation in Bulgaria's financial sector.

A Schengen-style path to the euro?

The biggest question is whether accession to ERM II will become another rocky path like accession to Schengen. Bulgaria has been trying to enter the EU's borderless area for years but new considerations whether the country has met the conditions emerge all the time. According to the European Commission, Bulgaria was ready to enter as early as 2011, but still there is not a set date for entry. Consequently, the same worry now makes the banking sector anxious whether the ECB will take a conservative approach towards Bulgaria, making its efforts to enter the eurozone longer.

"It will become clear whether this is another Schengen within a year at the earliest," Petar Ganev, Senior Research Fellow at the Institute for Market Economics, said. The Eurogroup voiced their support and will probably not object to Bulgaria joining the ERM II if it complies with the ECB requirements. In contrast, Bulgaria's application to join Schengen has never received official support from the EU member states.

One of the main worries in Bulgaria is whether the country has to take on additional measures to fight corruption. There is language in that sense in the July Eurogroup and ECB joint statement, referring to the European Commission's monitoring of Bulgaria's judicial system. This has been exactly the argument used to postpone Bulgaria's entry into Schengen. Valdis Dombrovskis, European Commission vice-president for the euro, however, has underlined nobody expects such a thing. "We have discussed this with the ECB and the EC, and none of our partners is using this as a precondition for ERM II."

How long is the path?

All of this means the Bulgarian government has to be very focused and willing to actively pursue reforms within the financial sector. Depending on how well the country follows on the ECB recommendations, the path to the euro could be walked within a few years, or, judging from the unsuccessful efforts with the Schengen area, might be an ever moving target.

The minimum stay in the ERM II is two years or as much as Slovenia, Slovakia, Cyprus and Malta waited to join the eurozone. This, of course, was before the financial crisis which made Europe way more cautious and anxious and pushed back the entry of the Baltic countries in the monetary union by 7-10 years. Within its resting period in ERM II, Bulgaria has to comply with certain rules, one of which is stable currency. The hardest for the country will be keeping inflation within 1.5 points above the three best performing member states. Other requirements include low national debt and budget deficit, which are for the government to meet.

Yet, these are only the main commitments set out for Bulgaria, with analysts waiting to see the hidden bumps on the road.