Monetary Transmission and Bank Lending Channel under the Currency Board: The Case of Bulgaria, 1999-2010

How do transitional economies’ banking sectors transmit monetary policy? In particular, how does monetary policy interact with bank lending under a currency board regime? In the Bulgarian currency board regime, the lev is irrevocably fixed in terms of the anchor currency, the euro, and the Eurozone monetary shocks are mainly transmitted to the Bulgarian economy through changes in the key interest rates and the monetary base. Moreover, Bulgarian banks, mostly foreign owned, remain dependent on parent banks located in the Eurozone economies for funding corporate loans. These special features of the Bulgarian monetary and banking environment warrant a detailed study of the monetary transmission of the Eurozone shocks to its domestic financial sector, in particular, to the bank system and its ability to extend loans. After assessing the relative strength of monetary integration between Bulgaria and the Eurozone by means of cointegration methodology, this chapter studies the bank lending channel of monetary transmission using a panel of quarterly time series of Bulgarian commercial banks for the period 2001- 2010 with a focus on the differential effects of monetary policy shocks on the growth rate of loans for banks with different characteristics. The econometric results, based on dynamic panel specifications of the Generalized method of moments (GMM) methodology suggest that banks respond strongly, in terms of their lending, to monetary impulses as measured by the base interest rate but the degree of its intensity varies with several bank specific measures, such as size, capitalization, and liquidity. This is taken as evidence for the presence of the lending channel in the Bulgarian case. The chapter also claims that the policy reaction of the BNB to the credit boom of 2002-2007 and the subsequent global financial crisis implies an active macro-prudential oversight on the financial sector despite the limited number of instruments at its disposal. Although the data is brief, an attempt is also made to capture the impact of the global financial crisis (2007-2009) on the bank lending channel in the Bulgarian context.