Interview with Toby Iles, analyst for Central & Eastern Europe at the Economist Intelligence Unit (EIU)

After gaining a first class undergraduate degree from the University of Oxford, Toby Iles undertook further study at the University of Cambridge and the Diplomatic Academy of Vienna. Subsequent to this he joined the Economist Intelligence Unit (EIU) in Vienna as a research analyst covering Central Eastern Europe, the Middle East and Africa. After three years in this role he switched to the London office to join the team of analysts producing the main EIU products for Eastern Europe. As such he has responsibility for Bulgaria, Croatia and Romania, producing the economic forecasts and regular reports, as well as being the point of contact for corporate questions and speaking at conferences.

The Greek crisis has triggered fears about the stability of the eurozone and concerns that it may end up foiling Bulgaria's aspirations to join the euro in three years, despite the country's budgetary rigor. Could the debt crisis erupting across the currency bloc harm Bulgaria's euro-zone bid?

There has been considerable discussion of whether the Greek crisis is likely to affect the path of the new EU member states towards economic and monetary union. EU policymakers, who had already shown a tendency towards a very strict application of the Maastricht criteria for euro adoption, will now cast an even warier eye not only on these criteria, but on a broader set of parameters. These are likely to include the sustainability of external balances and broader measures of the economy's performance and competitiveness. In the wake of the fast-and-loose approach to statistical reporting adopted by Greece, EU bodies will also place the statistical releases of EMU applicants under more intense scrutiny, particularly with regard to their fiscal accounts.

Bulgaria's recent fiscal prudence is a major positive for its bid to enter ERM II and then adopt the euro. Nevertheless, it is no secret that some established euro members have concerns about admitting faster-growing economies to the euro club, owing to the perceived greater risk of imbalances, which may undermine confidence in the single currency. The Greek crisis is likely to exacerbate these cautious tendencies. In Bulgaria's case, the current-account deficit and the level of external debt are likely to be scrutinised. The current-account deficit has declined dramatically in 2009 but remains large as a percentage of GDP, and EU policymakers will be worried that the deficit will increase again once GDP growth resumes at faster rates. The Bulgarian convergence document has tried to allay this fear, by emphasising the structural reforms designed to enhance competitiveness and productivity.

In short, yes, the Greek crisis could harm Bulgaria's euro zone bid.

Is Bulgaria among the countries most at risk from potential spillovers from Greece after banks invested in central and eastern Europe? Is the country more susceptible to contagion risk from than neighboring Romania or Turkey?

Within eastern Europe Bulgaria is probably the most vulnerable to negative spill-over effects from the crisis in Greece, owing to strong trade and investment links with Greece and the substantial stake Greek banks have in Bulgaria's banking sector.

Greece needs to severely tighten its fiscal policy and, whatever support is forthcoming from the EU, the country is at risk of remaining in recession throughout 2010 at least. Bulgaria is unlikely to be immune to the hardships in Greece. Greece has been one of the main sources of foreign direct investment in Bulgaria and Greek demand has been accounting for around 10% of Bulgarian exports in recent years. Therefore, there is a risk that lower trade and investment could shade a few decimal points off Bulgarian real GDP growth in 2010. More serious perhaps is the risk of a damaging retrenchment by the Greek banks operating in Bulgaria. Greek banks account for almost 30% of total assets and 40% of loans in the Bulgarian banking system (higher ratios than in Romania, or other eastern European countries), which has experienced a sharp slowdown in credit growth in 2009 and an ongoing rise in non-performing loans. While the Greek banks will not wish to damage their reputational credibility in the Bulgarian market, there is a strong risk that pressure in their home market could drive them to limit credit activity abroad, including Bulgaria. This would certainly knock the moderate recovery in credit growth forecast for Bulgaria in 2010 and as a consequence undermine economic recovery. We forecast an anaemic recovery in Bulgaria in 2010, with real GDP growth of 0.6%. However, the combination of lower trade and investment, together with weaker credit growth, flowing from the Greek crisis could cause the Bulgarian economy to remain flat in 2010 or even fall back into recession.

What is the realistic deadline for Bulgaria to apply to the bloc's exchange-rate mechanism, the so-called Eurozone waiting room and the eurozone? When will Brussels allow Bulgaria to do so?

At the end of January 2010 the government approved and submitted to the European Commission Bulgaria's convergence programme up to 2012, as required at the initial stage of applying for membership of the EU's exchange-rate mechanism (ERM II). The programme states that the main medium-term objective of Bulgarian economic policy is euro area membership, in order to enhance macroeconomic stability and boost investor confidence in the Bulgarian economy. To this end the government is seeking entry into ERM II. After securing ERM II membership Bulgaria would have to remain in fulfilment of the Maastricht criteria for at least two years before euro adoption.

Bulgaria must now wait for the EU evaluation of its convergence programme. Meanwhile, the Commission will produce a detailed report on the Bulgarian economy and its readiness for ERM II. The Bulgarian government will hope to join ERM II later in 2010, although Mr Borisov has admitted that the aim to adopt the euro by 2013 will be a struggle. We anticipate that Bulgaria may get to adopt the euro in 2014 at the earliest.

What will it take to persuade European leaders that the Bulgarian government will be fiscally disciplined now and in the future?

One issue on which Bulgaria can be fairly confident is fiscal policy. In 2009 the country posted an estimated general budget deficit of 0.8% of GDP, which was the smallest deficit among EU countries. Given the currency board arrangement, fiscal policy, rather than monetary policy, is Bulgaria's main policy weapon, and in recent years surpluses have been the norm. According to the convergence programme, fiscal policy in the medium term will aim for balanced budgets in order to ensure the sustainability of the public finances.

Should Bulgarian policy makers be cautious about entering the single currency club? What are the risks if the country adopts the euro too early?

In general, one risk for a country of joining the euro is to lose control over competitiveness, because you can't devalue your currency. In Greece, for example, wages rose very quickly, in part due to expansionary fiscal policy. This fueled private consumption and a large current-account deficit. However, Greece was unable to act against this with monetary policy by devaluing. In Bulgaria, though, the lev has been pegged to the euro for more than a decade and so Bulgaria has not been using currency devaluations to maintain competitiveness. Therefore, this risk is not so much of an issue for Bulgaria, as it is for the likes of Poland and the Czech Republic, which have floating exchange rates. Nevertheless, in a hypothetical situation of diminishing competitiveness in several years time, it would be even more difficult to leave the euro than abandon the currency board arrangement.

Another risk from adopting the euro too early stems from insufficient real convergence, as reflected in the significant disparity of income and price levels between Bulgaria and the average for the EU. If this is the case then adoption of the euro can lead to price rises which people are not prepared for. This issue was recently raised with regard to Bulgaria by Jorge Fuentes, Spain's ambassador to Bulgaria.

Do you think that outpacing such countries as Poland in euro adoption could raise eyebrows in Brussels and other European capitals where Bulgaria remains synonymous with corruption and organized crime?

Although the process of adopting the euro is based on defined economic criteria, it would be naïve to think that political sentiment is therefore unimportant. It is a political process also and Bulgaria's relations with the EU since membership in 2007 have not been smooth. Nevertheless, the advent of the new government in July 2009 provided a platform for better relations with the EU and Bulgaria needs to capitalise on this.

Can the fiscal problems of some of the members in the eurozone sink the euro or trigger their expulsions?

At present we think that a collapse of the euro is highly unlikely, as are expulsions from the euro zone. Nevertheless, the magnitude of this crisis for the EU should not be underestimated given the questions that it raises about the inadequacies of the economic and monetary union as it currently operates.

What will be the impact on those countries, which will have to pick up the tab, such as Germany and France?

Germany's coalition government has reluctantly lent its weight to euro area efforts to help the Greek government avoid default on its massive public debt, despite the fact that opinion polls show strong public opposition to assisting Greece. This will certainly be onerous for Germany and the public mood could sour further as and when the costs of aiding Greece become a reality.

The German government supported the rescue plan because it feared that, however great the potential financial and political cost of bailing Greece out, it would be more costly to allow the sort of potential economic and financial meltdown that could occur if Greek default triggered a wave of sovereign defaults. Among other things, German banks have huge exposure to southern European countries. According to figures compiled by the Bank for International Settlements (BIS)—a sort of central bank of national central banks—German financial institutions' lending to banks, corporates, households and the public sector in Italy, Spain, Greece and Portugal amounts to just under USD 525 B.

On top of these economic considerations, much of the German political class feels a deep commitment to European integration, which is seen by them as an integral part of Germany's post-war and post-reunification geopolitical identity. The minister of finance, Wolfgang Schäuble, a committed integrationist and one of the most influential politicians in Ms Merkel's cabinet, was among those pushing hard for a European solution to the crisis.

Will the price of monetary union give a pause to the tiny Baltic states, which have pursued closer integration with Europe with enormous zeal? Does the euro look as attractive to them now as before?

All new EU entrants are bound by their accession treaties to eventually adopt the euro, but with budgets strained by the recession and the notion of EMU as a safe haven somewhat discredited, the impetus for rapid accession has in some cases been lost. In the Baltic states, however, commitment to adopting the euro still seems to be strong, despite the painful policies they are currently pursuing to fulfil the Maastricht criteria.

Estonia’s political leaders have thus far avoided the question of whether the debt difficulties faced by Greece and other members of the euro zone might lead to a re-examination of Estonia’s urgent push to adopt the single currency. Estonia hopes to adopt the euro in 2011 (although on balance we think that 2012-13 is a more realistic date for euro adoption). However, there are some notes of scepticism from within the Estonian political establishment. Mart Laar, who has served two terms as prime minister and was the prime architect of Estonia’s transition to a market economy, publicly warned that unemployment could become an obstacle to euro zone accession. Mr Laar noted that the rapidly rising rate of unemployment will increase pressure on the public finances, and suggested that it might bring into doubt the long-term ability of Estonia to comply with the Maastricht criteria. Importantly, Mr Laar is a senior member of Pro-Patria-Res Publica Union, one of the two parties in the ruling minority coalition.

There have not been any major signs in Latvia and Lithuania that the euro has become a less attractive prospect. The Latvian government has said that it will narrow the budget deficit to 3% of GDP by 2012, which would allow euro zone entry in 2014. However, the fiscal adjustment required in 2010-12 to achieve this target appears too challenging, and the Economist Intelligence Unit does not expect Latvia to enter the euro zone until 2015 at the earliest, with a considerable chance of further delay. In Lithuania, the authorities are committed to meeting the Maastricht criteria in the hope of joining the euro zone in 2011-12. Until recently, a relatively high level of inflation was the main barrier to euro zone entry, but we expect the budget deficit to breach the 3% of GDP Maastricht limit in 2010-11, which is likely to make euro adoption impossible until at least 2014.

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