The Bulgarian lev (BNG) is pegged to the euro through a currency board agreement: €1 equals 1.955 lev.
What is a currency board?
A currency board combines three elements: a fixed exchange rate between a country's currency and an “anchor currency”, automatic convertibility and a long-term commitment to the system, often expressly set out in the central bank law. The main reason countries consider a currency board is to demonstrate their commitment to an anti-inflation policy.
A currency board is credible only if the country’s central bank holds sufficient foreign-exchange reserves to cover at least its monetary liabilities, thus assuring financial markets and the general public that every bill in the national currency is backed by an equivalent amount of foreign currency in the official vaults. Demand for a ‘currency-board currency’ is higher than for a currency without guarantees, because holders know that, come rain or shine, their money can easily be exchanged for one of the major foreign currencies. The system’s architects argue that automatic stabilisers should prevent large outflows of foreign currency.
The mechanism works through changes in the money supply that lead to changes in interest rates, which in turn encourage funds to move between the national currency and the anchor currency. This is essentially the same mechanism that operates under a fixed exchange rate, but the guarantee built into the currency board’s exchange rules ensures that the necessary interest-rate changes and the associated costs to the economy will be relatively low.
The obvious advantages of a currency board are economic credibility, low inflation and low interest rates. However, a currency board can prove restrictive, particularly for countries with weak banking systems or those prone to economic shocks. With a currency board in operation, the central bank cannot act as lender of last resort to troubled banks. At most, it may act through an emergency fund set aside when the currency board was introduced or funded over time from the central bank’s profits. Another disadvantage is that under a currency board, financial policies and adjustments to interest rates or the exchange rate cannot be used to stimulate the economy. Instead, economic adjustment can be achieved only through adjustments to wages and prices, which may be slower and more painful.