Inflation in Bulgaria: Convergence or EU-phoria?

1. Inflation in Bulgaria:Convergence or EU-phoria? Jianping Zhou1/ International Monetary Fund May 2, 2007 1/ The views presented here are those of the author and are not to be interpreted as those of the IMF. Please do not quote without author’s permission.

2. Background/Motivation • Bulgaria’s joining the euro zone now hinges on its ability to reduce its inflation differential vis-à-vis the euro zone. • Remarkable progress was made over the last 10 years in bringing down the hyperinflation to a single-digit rate today. • However, inflation has risen in recent years and inflation gap widened, to 5 percentage points in 2006, although partly due one-off adjustments. • Large inflation gaps exist also in many other new EU member states (NMS).

3. Background/Motivation

4. Background/Motivation • The government is committed to early adoption of the euro and confident in reducing inflation. • There is increasing skepticism that the NMS will be able to fulfill the inflation criterion by their targeted dates for joining the euro(about three years from now for most of them) and whether they even should (Kopits, 2006). • Price convergence: closer integration with Europe significantly increased trade and capital flows, weakened “border effects” and reduced price dispersions (Rogers, 2007). • Income convergence: productivity catch-up • The Balassa-Samuelson effect: faster catch-up in tradables sector relative to nontradables sector

5. Background/Motivation • The role of domestic policies may be limited (Mody and Ohnsorge, 2006); a transitional recession might be necessary to depress inflation (Buiter and Grafe, 2002). • The persistence of inflation differentials across the euro area countries since the introduction of the euro also lends support to those opposing the inflation criterion.

7. Background/Motivation • High inflation, even transitory, should be a matter of concern • when feeding into wage decisions, it may amplify cyclical fluctuations • when a country with higher inflation is also faced with lower real interest rates, it could lead to excessive household debt accumulation, over investment, and asset bubbles • Large and continually rising current account deficits in Bulgaria and many other NMS raise questions about whether higher inflation might partly reflect “EU-phoria”: expectations of rapid income convergence and higher income propelled by prospects of euro entry.

8. Countries with high inflation tend to have larger current account deficits.

9. A summary • Stylized facts about inflation in Bulgaria • A theoretical model • Examines the impacts of the B-S and the EIC effects on inflation, consumption, output, and the current account balance • Provides basis for the empirical framework • Empirical investigations • Partial correlations and panel regressions • Preliminary results

10. Inflation gap was closed in 2003 (and inflation criteria met), but has widened since then

11. The impact of administrative price adjustments • In 2006: 21 percent of the prices under the government control; a large increase in excise duties for tobacco. • This share is higher than in 2000 (17 percent). • Increases in these prices added about 1 percentage point to the average inflation rate. • it is not clear whether inflation would be lower without these price controls. • Inflation excluding these prices has been highly correlated with the overall inflation.

12. Higher inflation in the nontradables sector than in the tradables sector.

13. Why would prices of nontradable goods increase faster? • The Balassa-Samuelson effect • Relatively higher productivity growth in the tradables sector • Differences in market structures (e.g., the degree of competition) • Mody and Ohnsorge, 2006 • Arratibel and others, 2002 • Expected faster income convergence • Results from the theoretical model

14. The representative consumer with perfect foresight expectations maximize an intertemporal utility function.

15. The representative firm produces the trade and non-traded goods with the following production function:

16. The consumer’s budget constraints are:

17. Impact of current and expected changes in productivity on current inflation • First term captures the classical Balasaa-Samuelson effect: an increase in the productivity in tradable sector relative to non-tradable sector raises the domestic price level b/c it increases the consumption of the tradable good relative to the non-tradable good. • Second and third terms capture the impact of expected productivity growth.

18. Impact of the B-S effect and expected productivity growth on inflation, consumption, output, and the current account balance

19. Main results from the model: • Both the B-S and the EIC (measured by expected productivity growth) effects would result in higher price increases in non-tradable sector, thus leading to high inflation. • They would have different impact on the relative output of the tradable and non-tradable goods. • If the Balassa-Samuelson effect is at work, we should observe that the increase in domestic demand for the tradable good is offset by an increase in supply, so that the trade balance does not change. • By contrast, with the expected income convergence the increase in demand is not matched by an equivalent increase in supply and leads to a trade deficit. • The presence of large current account deficit is an indication that the EIC might be partly responsible for the rising inflation in recent years.

20. Empirical evidence of the B-S effect • Many studies investigating the sizable cross-country differences in inflation in the euro area find little or no evidence of the BS effect (Honohan and Lane, 2003 & 2007; Roger, 2007; Mody and Ohnsorge, 2006). • For the transition countries in Europe, the estimated B-S effect on inflation ranges from zero to 4 percentage points (Mihaljek and Klau,2003). • Existing studies on Bulgaria tend to find small or insignificant B-S effect on inflation(AEAP, 2006; and Nenovsky and Dimitrova, 2002). • Reasons: price liberalization, rigidities in product and labor markets.

21. Empirical evidence of the B-S effect • Prices of non-traded goods have been rising much faster than the prices of the traded goods, but not due to the BS effect. • Productivity has been rising faster in the nontradables sector, contrary to the B-S hypothesis. • Employment in the non-tradable sector grew much more rapidly than in the tradable sector.

22. Higher productivity growth across most subsectors: financial, business, personal, and real estate-related services, wholesale and retail sectors

23. Bulgaria is not alone ...

24. Poor NMS tend to converge faster, but Bulgaria is below the line

25. Convergence speed: Bulgaria (1%), vs. Ireland (2.5%).

26. Poorer NMS are associated with higher inflation, but Bulgaria is above the line

27. The convergence process has been accompanied by accelerated capital inflows, adding inflationary pressures

28. Based on the correlation in Figure 14, Bulgaria’s inflation should be about 4 percent

29. Same holds for average inflation in 2004-06

30. Its current account deficit should be about 10 percent of GDP (similar to what implied by Blanchard & Giavazzi, 2002)

31. To the extent that CAB reflects expectations for higher future income, economic agents in Bulgaria appear to be becoming increasingly optimistic.

32. Panel regressions

33. Preliminary results • We find no significant Balassa-Samuelson effect on inflation in Bulgaria. • It is possible that “EU-phoria” or expected rapid income convergence is partly responsible for the relatively higher inflation in Bulgaria. • Is inflation in Bulgaria too high? • Past performances • Standards set by certain countries (e.g., Ireland) • Supply side polices needed to ensure rapid income convergence

34. Concluding remarks • The large current account deficit, buoyant credit growth, and inflationary pressures all point to a certain degree of “EU-phoria”: expectations of faster convergence and higher future income. • The presence of the risks associated with unrealized expectations, either because of unexpected adverse external shocks or because of unsuccessful domestic policies to deliver expected high productivity growth, underlines the need for policy safeguards. • With the currency board arrangement in place, tight fiscal policy remains the key instrument in containing domestic demand and reducing overheating. • Other important measures would include prudent wage policies, strengthened financial regulation and supervisions, and last but most importantly, structural reforms to improve the flexibility of the economy.

35. Some caveats • Empirical results are based on work in progress, and should be interpreted with cautions. • CAB may be capturing other effects, e.g., trade and financial integration • Data issues • Policy discussions emphasize on the risks associated with volatile expectations, not on whether these expectation are “exuberant” • Future work to better capture the degree of “EU-phoria” • Stochastic expectations • Engel and Rogers (2006): the expected future US growth is measured by its expected future share of world GDP to its current share of world GDP