Bulgaria Euro Bid Is Said to Stoke ECB Doubts as Latvia Festers

(Bloomberg) -- The European Central Bank has fresh cause to think twice about an expansion of the euro zone into an Eastern European country with a history of troubled lenders.

Just as the Frankfurt institution reels from revelations over Latvia’s financial system and the detention of its central-bank governor, some officials are bracing for the prospect that, within months, they’ll be consulted on another membership application from the region.

While Bulgaria broadly fulfills the convergence criteria, its banks are seen as the key weakness in its prospective bid to join the euro, according to two people familiar with the discussions, who asked not to be identified because the matter is confidential.

The European Union’s poorest country currently holds the bloc’s rotating presidency and wants to make its application to enter the exchange-rate mechanism, a waiting room for euro membership, by June, when its chairing role concludes.

The ECB has a formal role in advising on expansion and that responsibility is all the greater now that it supervises lenders across the euro zone. Ultimately though, the decision rests with EU governments which have been keen to spread the reach of the single currency.

“Bulgaria certainly has more homework to do with its banking sector than some other east EU countries,” said Raffaella Tenconi, an economist at ADA Economics Ltd. in London. “But in my experience, once a country meets nominal criteria, its bid won’t be rejected.”

Bulgaria Euro Bid Is Said to Stoke ECB Doubts as Latvia Festers

This week’s news from Latvia, involving bribery allegations against Governor Ilmars Rimsevics, which he denies, and a payments freeze on a bank facing U.S. enforcement action, has evoked memories of Bulgaria’s 2014 banking crisis. That turmoil was sparked by the failure of Corporate Commercial Bank AD, the country’s fourth-biggest lender. Two former deputy central bank governors were later charged for poor supervision, and former Governor Ivan Iskrov resigned shortly before his term ended in 2015.

There’s no connection between the events in Latvia and Bulgaria’s ERM application, the Bulgarian central bank said in an e-mail. An ECB spokesman declined to comment on the country’s prospective membership.

In the aftermath of its crises, the Bulgarian central bank revamped supervision. In 2016, it carried out stress tests showing that its banking system, consisting of 22 institutions and five branches of foreign lenders, is overall robust, but with “pockets of weaknesses,’’ according to the European Commission. Two domestically owned banks, including the third-largest lender, First Investment Bank, needed to replenish capital buffers.

IMF Verdict

The International Monetary Fund lauded the country for “significant progress.” In its more recent assessment on Thursday, it said that the banking system is “resilient” but that the two lenders highlighted in 2016 still need more capital.

Bulgaria Euro Bid Is Said to Stoke ECB Doubts as Latvia Festers

While the banking system’s common equity Tier 1 ratio, at about 20 percent, is more than quadruple the minimum legal requirement, both the European Commission and the IMF remain concerned about non-performing loans. Their share of total lending fell to 10.2 percent last year from 12.8 percent in 2016, though that’s still more than double the EU average.

As Bulgaria steps up preparations for its euro bid, its pitch includes a budget surplus last year and public debt at only 25 percent of gross domestic product -- well within the EU’s rules and one of the lowest in the bloc.

Bulgaria would first need to join the exchange-rate mechanism, known as ERM-2, for a minimum of two years. It’s already won endorsements for that move from European Commission President Jean-Claude Juncker, German Chancellor Angela Merkel and French President Emanuel Macron.

Juncker has said the Bulgarian government has made “significant progress” and has urged the country to lock its currency in the ERM-2 “as soon as possible.” The lev has already been pegged to the euro under a currency board system imposed 20 years ago.

Money Laundering

The ECB will comment on the country’s readiness in a report due in May, and the prelude to euro adoption may be when it has the most leverage to impose change. Latvia shows the limits of its influence afterwards: the central bank has no power to fight money laundering or to investigate the governance shortcomings that give rise to it, ECB supervision chief Daniele Nouy said on Thursday in the institution’s first statement on events in the Baltic country.

ECB officials have made cautious noises of encouragement on Bulgaria. Executive Board Member Peter Praet said in the Bulgarian capital, Sofia, last May that its formal compliance with convergence criteria “looks quite good,” though “we’ve been insisting in all analysis very much about institutional capacity, institutional building.”

Bulgaria’s entry to ERM-2 would be the first since the ECB took charge of banking supervision, giving greater weight to its decisions in the matter. Its objections have previously delayed accession.

“It’s not easy for the ECB to play hardball this time. The European Commission is clearly supportive and the ECB is the one that is less optimistic,” said Gunter Deuber, an analyst at Raiffeisen Bank International AG in Vienna. “From the oversight and regulatory perspective it’s hard to say they are not ready. Yes, it’s a bit of an oligarch economy, but these things are hard to measure.”

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