How Currency Devaluation Leads to 'Lost Decade'


For countries such as Greece, leaving the euro and returning to a national currency has been touted as a potential panacea for a return to competitiveness, growth and stability. However, Bulgaria, a country that devalued its currency to regain competitiveness is now seen in limbo in a "lost decade."

Bulgaria was until recently perceived as an "island of tranquility" amid the euro zone's turmoil. In Fall 2012, the country's president boasted to CNBC that his country was enjoying a competitive tax regime, good fiscal health and a budget surplus after a giant bust following the financial crisis.

Economists beg to differ, however, saying that internal devaluation of Bulgaria's currency, the Lev, has created a nightmare scenario in which Bulgaria "appears to be stuck in a vicious cycle of weak growth, fiscal austerity and a stubbornly high debt burden."

(Read More: Devaluing Your Currency Not a Panacea After All)

In a report entitled "Bulgaria's lost decade" released on Thursday, Neil Shearing and Liza Ermolenko, economists at Capital Economics said the roots of Bulgaria's misfortunes could be attributed to the imbalances built up in the country's boom years, as well as the method applied to stop the rot: internal devaluation. That strategy was also mooted as a potential cure-all for Greece at the height of euro-exit speculation.

Does Devaluation Work?

The economists' report notes that Bulgaria's attempts to restore competitiveness and facilitate a shift towards a more export-orientated growth model were flawed, as the Bulgarian Lev is pegged to the euro.

"Bulgaria's fixed exchange rate meant that it had to undergo a process of 'internal devaluation' instead, whereby competitiveness is restored with falls in wages and prices. As things stand, despite several years of austerity this process still has further to run," Shearing and Ermolenko note.

"Had the country had a floating exchange rate, regaining competitiveness would be done via a drop in the currency which would facilitate a shift towards a more export-orientated growth model."

Shearing and Ermolenko note that "internal devaluation" has raised a different set of problems in Bulgaria with the required falls in wages and prices set to increase the real value of domestic debt, thus working against much-needed deleveraging" a factor leading to the afore-mentioned "vicious cycle of weak growth, austerity and stubbornly high debt."

"Internal devaluation" has been seen to work in Bulgaria's fellow "BELL" economies, Latvia, Lithuania and Estonia if the Baltic nations' return to growth, after suffering similar real estate crashes to Bulgaria, is taken as an example.

(Read More: Role Model of European Austerity Turns to Stimulus)

But rather than aid Bulgaria's ailing economy- which Shearing and Ermolenko forecast will see growth of 2 percent a year (well below pre-crisis levels of 6 percent) – it may take until 2015 for Bulgaria's economic output to return to 2008 levels.

"If this is the case, the Bulgarian economy will have lost close to a decade of growth," they note,

Bulgaria's Boom and Bust

The co-authors of a report entitled "Bulgaria's lost decade" say that Bulgaria's predicament has its roots in imbalances that were built up by the country before the 2008 financial crisis.

Similar to Latvia, Bulgaria experienced huge capital inflows - particularly into real estate. This resulted in excessive borrowing by the private sector, a boom in domestic demand and a corresponding widening of the current account deficit.

At the same time, high inflation and rapid wage growth resulted in a substantial loss of competitiveness against a backdrop of a fixed exchange rate, Shearing and Ermolenko note in the report.