Inflation in Bulgaria: Convergence or EUphoria

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Inflation in BulgariaConvergence 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 Please do not quote without authors
  permission.

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Background/Motivation

• Bulgarias 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).

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Background/Motivation
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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

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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.

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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.

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

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

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

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

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

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The consumers budget constraints are

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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.

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

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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.

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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.

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Higher productivity growth across most
subsectors financial, business, personal, and
real estate-related services, wholesale and
retail sectors
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Bulgaria is not alone ...
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Poor NMS tend to converge faster, but Bulgaria is
below the line
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Convergence speed Bulgaria (1), vs. Ireland
(2.5).
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Poorer NMS are associated with higher inflation,
but Bulgaria is above the line
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The convergence process has been accompanied by
accelerated capital inflows, adding inflationary
pressures
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Based on the correlation in Figure 14, Bulgarias
inflation should be about 4 percent
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Same holds for average inflation in 2004-06
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Its current account deficit should be about 10
percent of GDP (similar to what implied by
Blanchard Giavazzi, 2002)
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To the extent that CAB reflects expectations for
higher future income, economic agents in Bulgaria
appear to be becoming increasingly optimistic.
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Panel regressions

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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

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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.

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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