After lagging behind the rest of Eastern Europe during 1989-90, Bulgaria introduced a programme of macroeconomic reform and liberalization in February 1991 which is even more radical than the Polish programme of January 1990. In Discussion Paper No. 549, Research Fellow Gordon Hughes outlines Bulgaria's earlier macroeconomic development and assesses the conditions required for the reform to achieve both macroeconomic stabilization and the elimination of price distortions by 1992. Following its transformation from a predominantly agricultural to an industrial economy in 1950-70, Bulgaria maintained rapid economic growth until the early 1980s. In the late 1980s, however, growth slowed, the trade balance deteriorated and the budget deficit grew until the government had to suspend payments on foreign debt in March 1990. Political uncertainty, a lack of foreign exchange and ill- considered price reforms then led to a sharp reduction in output and accelerating inflation, which were further exacerbated by the collapse of East European intra-trade and rising oil prices following the invasion of Kuwait.

Most price controls have already been removed, even the controlled prices on food and energy have risen by up to 650%. Multiple exchange rates have been eliminated in favour of a free float, and monetary discipline on banks and enterprises has also been relaxed. Hughes argues that the target of maintaining inflation below 10% per annum from 1992 onwards is too ambitious for two reasons. First, the exchange rate will probably settle below the level the programme envisages; second, domestic energy and food prices still remain below world prices even at the current exchange rate.

Hughes investigates these factors' influence on the prospects of the reform's success by constructing a modified input-output pricing model to focus on the adjustment mechanisms of the exchange rate, wages, controlled prices and the profitability of industrial enterprises under alternative policy rules. His results suggest that the government could achieve both macroeconomic stabilization and non-distortionary prices by adopting a fixed real exchange rate at about 25% below its December 1990 level (i.e. below the 15% depreciation the reform programme assumes will result from a free float). Inflation should then stabilize at 20-25% in 1993-4. Although inflation in the second half of 1991 will be higher than the reform programme envisages, the stimulus to economic activity and the trade balance will be much greater.

Hughes notes in conclusion that the feedback effects on inflation and economic activity of allowing the exchange rate to be freely determined in the foreign exchange market would threaten the success of Bulgaria's entire reform programme. He therefore advocates a less ambitious but more achievable exchange rate policy that will improve the prospects for the reform's success.

Foreign Exchange, Prices and Economic Activity in BulgariaGordon Hughes

Discussion Paper No. 549, May 1991 (IM)