Danish for All? Balancing Flexibility with Security: The
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Transcript Danish for All? Balancing Flexibility with Security: The
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 Please do not quote without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.
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).
Background/Motivation
Figure 1. Bulgaria: Inflation, 1998-2006
(Annual average, in percent)
20
8
Inflation in Bulgaria
18
Inflation in 2006
7
16
6
14
12
5
10
4
8
3
6
2
4
1
2
0
Best 3
Euro area
Poland
Slovenia
2006
Czech
Republic
2005
Lithuania
2004
Hungary
2003
Estonia
Source: WEO; Staff calculations.
2002
Slovak
Republic
2001
Latvia
2000
Romania
1999
Bulgaria
0
1998
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
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.
Figure 2. Euro Area and Selected NMS Countries: Dispersion of Inflation Rates
(12-month MA; in percent)
9
8
Euro Area
7
6
Max
5
4
Mean
3
2
Min
1
0
1997M1
1999M1
2001M1
2003M1
2005M1
2007M1
16
14
NMS countries with fixed exchange rates
12
10
Max
8
6
Bulgaria
Mean
4
2
Min
0
-2
1999M1
2000M1
2001M1
Sources: Eurostat; Staff calculations.
2002M1
2003M1
2004M1
2005M1
2006M1
2007M1
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.
Countries with high inflation tend to have larger current account deficits.
Figure 3. New EU Member States: Inflation and Current Account Deficit, 2006
25
Current Account Deficit (% of GDP)
Latvia
20
15
Bulgaria
Estonia
Lithuania
Romania
10
Slovak Republic
Hungary
Czech Republic
Slovenia
5
Poland
0
0
1
2
3
4
Inflation
Source: WEO and Staff calculations.
5
6
7
8
A summary
Stylized facts about inflation in Bulgaria
A theoretical model
Empirical investigations
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
Partial correlations and panel regressions
Preliminary results
Inflation gap was closed in 2003 (and inflation criteria met), but has
widened since then
60
HICP Inflation
50
40
30
Max
20
10
Bulgaria
Euroarea
0
Min
-10
1999M1
2000M1
2001M1
2002M1
2003M1
2004M1
2005M1
2006M1
2007M1
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.
Higher inflation in the nontradables sector than in the
tradables sector.
Figure 6. Bulgaria: Dual Inflation, 2001M1-2007M1
(in percent, 12-month y-o-y)
16
14
Non-tradable
Tradable
12
10
8
6
4
2
0
-2
2001M1
2002M1
2003M1
Sources: Eurostat; Staff calculations.
2004M1
2005M1
2006M1
2007M1
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
The representative consumer with perfect foresight
expectations maximize an intertemporal utility function.
U1 u(C1 ) u(C2 )
C1 1
u (C )
1
1
1 1
Ct CTt (1 ) CNt
1 1
Pt PTt1 (1 ) PNt
PTt SP*
1
1 1
The representative firm produces the trade and non-traded
goods with the following production function:
YT AT LT
YN AN LN
The consumer’s budget constraints are:
PN1CN1 PT 1CT 1 SF PN1YN1 PT 1YT 1
PN 2CN 2 PT 2CT 2 PN 2YN 2 PT 2YT 2 (1 r )SF
CNt YNt
CT 2
YT 2
CT 1
YT 1
1 r
1 r
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.
aT 1 aN 1 aT 2 aN 1
aN 2 aN 1
pN 1
2
2
2
Impact of the B-S effect and expected productivity
growth on inflation, consumption, output, and the
current account balance
a 1
pN 1 2
(a 2 a1 )
2
1
cT 1 cN 1
(a 2 a1 ) 2a
2
yT 1 yN1 2a
1
x1
(a 2 a1 )
2
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 nontradable 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.
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.
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.
0
Non-tradable sector
Tradable sector
Total
Other service activities
Financial, real-estate, renting and
business activities
Wholesale and retail trade, repairs,
hotels and restaurants; transport and
communications
Construction
Industry, including energy
100
Agriculture, fishing, etc.
Higher productivity growth across most subsectors: financial,
business, personal, and real estate-related services, wholesale
and retail sectors
120
Labor productivity growth, 2000-06
80
60
40
20
Bulgaria is not alone ...
Figure 10. Baltic Countries and Euro Zone: Sectoral Productivity, 2000-04
(in percent, accumulated growth)
70
Estonia
Latvia
Lithuania
Euro zone
60
50
40
30
20
10
0
-10
TOTAL MANUFACTURING,
EXCLUDING ELECTRICAL
MARKET SERVICES, EXCLUDING
POST AND
TELECOMMUNICATIONS
Source: European Commission; Staff estimates.
NON-MARKET SERVICES
Poor NMS tend to converge faster, but Bulgaria is
below the line
Figure 11. New EU Member States: Income Convergence
Increase in PPP per capita income, 2000-06
110
100
Latvia
90
Estonia
80
70
Lithuania
Romania
60
Bulgaria
Slovak Republic
50
Czech Republic
Hungary
Poland
40
Slovenia
30
20
5000
7000
9000
11000
13000
PPP per capita income, 2000
Source: WEO and Staff calculations.
15000
17000
19000
Convergence speed: Bulgaria (1%), vs. Ireland (2.5%).
90
80
PPP per capita income (% of euro area average)
2000
70
2006
60
50
40
30
20
10
0
Bulgaria
Romania
Poland
Latvia
Lithuania
Slovak
Republic
Estonia
Hungary
Czech
Republic
Slovenia
Poorer NMS are associated with higher inflation, but
Bulgaria is above the line
Figure 12. New EU Member States: Inflation Rate and Income Level, 2006
8
7
Bulgaria
Latvia
Romania
6
Inflation
5
Estonia
Slovak Republic
4
Hungary
Lithuania
Czech Republic
3
Slovenia
2
Poland
1
0
8000
10000
12000
14000
16000
18000
20000
PPP per capita income
Source: WEO and Staff calculations.
22000
24000
26000
The convergence process has been accompanied by
accelerated capital inflows, adding inflationary pressures
Figure 13. New EU Member States: Inflation Rate and Capital Inflows, 2006
20
Latvia
Estonia
Bulgaria
Capital Inflows (in percent of GDP)
15
Hungary
Lithuania
10
Romania
5
Czech Republic
Poland
Slovak Republic
0
Slovenia
-5
0
1
2
3
4
Inflation
Source: WEO and Staff calculations.
5
6
7
8
Based on the correlation in Figure 14, Bulgaria’s
inflation should be about 4 percent
Figure 14. New EU Member States: Inflation and Income Convergence
8
Bulgaria
7
Romania
Latvia
CPI inflation (2006)
6
5
Slovak Republic
Estonia
4
Hungary
3
Czech Republic
Lithuania
Slovenia
2
1
Poland
0
30
40
50
60
70
80
90
Increase in PPP per capita income (2000-06)
Source: WEO and Staff calculations.
100
110
Same holds for average inflation in 2004-06
Figure 14. New EU Member States: Inflation and Convergence
10
Romania
9
Average CPI inflation (2004-06)
8
7
Latvia
Bulgaria
6
Slovak Republic
5
Hungary
4
Estonia
Slovenia
3
Lithuania
Czech Republic
Poland
2
1
0
30
40
50
60
70
80
90
Increase in PPP per capita income (2000-06)
Source: WEO and Staff calculations.
100
110
Its current account deficit should be about 10 percent of GDP
(similar to what implied by Blanchard & Giavazzi, 2002)
Figure 15. New EU Member States: Current Account Deficit and Income Convergence Income
Level
25
Latvia
Average CAD (2006, % of GDP)
20
EU-phoria
15
Estonia
Bulgaria
Lithuania
10
Romania
Slovak Republic
Hungary
Czech Republic
5
Slovenia
Poland
0
30
40
50
60
70
80
90
Increase in PPP per capita income (2000-06; percent)
Source: WEO and Staff calculations.
100
110
To the extent that CAB reflects expectations for higher future
income, economic agents in Bulgaria appear to be becoming
increasingly optimistic.
Figure 15. New EU Member States: Current Account deficit and Initial Income Level
12
Estonia
Latvia
Average CAD (2000-06, % of GDP)
10
8
Bulgaria
Hungary
Lithuania
Slovak Republic
Romania
6
Czech Republic
4
Poland
2
Slovenia
0
30
40
50
60
70
80
Increase in PPP per capita income (2000-06)
Source: WEO and Staff calculations.
90
100
110
Panel regressions
Table 1. Estimated Equations 1/
Dependent variable: HICP inflation
Constant
Balassa-Samuelson effect
EU-phoria effect:
LP growth in t+1
Equation (1)
1.58 ***
5.15
0.00
-0.08
Output gaps
R-sq:
1.11 ***
4.98
0.02
0.87
Equation (3)
1.17 ***
5.60
-0.14 *
-1.94
Current account deficit
Inflation in t-1
Equation (2)
0.41 ***
4.63
0.31 ***
5.56
0.07
1.36
0.51 ***
6.15
0.30 ***
4.60
0.07
1.38
0.49 ***
6.11
0.26 ***
4.53
Within
0.53
0.48
0.47
Between
0.78
0.86
0.87
Overall
0.63
0.65
0.65
Source: IMF staff estimates.
1/Based on the fixed-effect estimations. Italic numbers are t-statistics; *, **, and *** represent statistical significance at 10 percent,
5 percent, and 1 percent, respectively.
Equation (4)
1.66 ***
5.54
0.00
-0.02
-0.17
-2.17
0.13
2.17
0.42
4.87
0.25
4.20
0.57
0.61
0.57
***
**
***
***
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
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.
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