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Bulgaria Exit of convalescence Following two years of political crisis amid sluggish growth, Bulgaria's political environment has stabilized since the legislative elections of late 2014, and economic activity has started to strengthen. In this context, the center-right coalition government led by Boiko Borisov has been able to introduce some structural reforms and pursue a fiscal adjustment program. The budget deficit soared in 2014 as spending increased to respond to social demands and provide liquidity support to local banks; but it then narrowed quickly and stood below 3% of GDP in 2015. In the banking sector, regulation is being improved and an asset quality review is planned for 2016. Banks remain plagued by large non-performing loans, and credit is unlikely to rebound in the short term. ■ Reform action in a stabilized political environment Bulgaria experienced a period of political and social turbulence following mass protests at the beginning of 2013, but the political environment has finally started to stabilize after the snap elections of October 2014. Since then, a center-right coalition government has been led by Prime Minister Boiko Borisov, the leader of the CEDB (Citizens for European Development of Bulgaria) and former government head from 2009-2013. There are still some risks of political instability going forward, because the ruling coalition may gradually weaken given its complex structure, and parties will soon prepare for the presidential election of October 2016. Moreover, the Bulgarians’ disillusionment with the political establishment remains significant. Nevertheless, in the more stable environment of the last 18 months, the government has succeeded in pursuing fiscal consolidation efforts and accelerating a number of structural reforms, despite the fragility of the coalition. Reforms that have recently been introduced or are due to be implemented shortly aim to start to improve the work of the Supreme Judicial Council, reorganize the education system, enhance efficiency in the electricity sector, and improve the health and pension systems. The authorities have also taken steps to strengthen the banking sector’s regulatory framework, with the adoption of the Bank Recovery and Resolution Directive (aimed at better handling crises), and plans to conduct an Asset Quality Review (AQR) and banking system stress tests by the end of 2016, with the support of the EU, IMF, and World Bank. Along with the accelerated reform process, relations with the EU have improved. In late 2014, the European Commission (EC) resumed payments to a series of environment-related projects that had been suspended due to problems in the public tendering process, and new investment programs have been approved for the 2014-2020 funding period. There is a consensus in Bulgaria on the need to enter the euro zone in the long term. In the short and medium terms, the authorities should remain strongly committed to preserving the Currency Board Arrangement (CBA) and thus maintaining policy discipline. Meanwhile, huge progress is still needed on the structural front. Governance and corruption problems, and the poor efficiency of the judiciary and the administration have long prevented Bulgaria’s “institutional convergence” with the EU and contributed to its incapacity to modernize infrastructure, thereby constraining its economic development. Bulgaria remains the poorest country in the EU, with GDP per capita (in PPP terms) at 47% of the EU average. Yet the situation might begin to change if the reform efforts underway since last year continue. A positive sentiment has also recently emerged thanks to economic growth acceleration. economic-research.bnpparibas.com 1- Summary of forecasts 2014 2015 2016f 2017f Real GDP grow th (%) 1.7 2.8 2.6 Inflation (CPI, y ear av erage, %) -1.6 -1.1 -0.5 1.2 Gen. Gov . balance / GDP (%) -5.8 -2.8 -2.5 -2.3 Gen. Gov . debt / GDP (%) 27.0 30.0 32.0 33.1 1.2 2.0 1.5 1.2 Ex ternal debt / GDP (%) 89.1 95.6 98.0 92.0 Forex reserv es (USD bn) 21.9 22.8 22.9 23.0 6.7 7.7 7.5 7.3 Ex change rate BGN/EUR (y ear end) 1.96 f: BNP Paribas Group Economic Research forecasts 1.96 1.96 1.96 Current account balance / GDP (%) Forex reserv es, in months of imports 2.6 2- Real GDP growth acceleration driven by exports Year-on-year change, 4pma, % — GFCF ▬ Exports - - - Government consumption ▬ Private consumption - - - Imports █ Real GDP (rhs) 25 10 20 8 15 6 10 4 5 2 0 0 -5 -2 -10 -4 -15 -6 -20 -8 -25 -10 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source : National Statistical Institute ■ Economic growth has gained some momentum Real GDP growth remained slow in the post-crisis period, averaging only 1.2% per year in 2010-2014. External demand from the main European partners was sluggish and domestic demand remained depressed, severely constrained by weak credit growth, high unemployment (which soared from 5.2% in Q4 2008 to 13.0% in Q2 2013 before starting to decline), political instability, weak confidence (aggravated by the crisis that hit two large local banks in 2014) and, more generally, the poor quality of the doing-business environment. Nonetheless, economic growth started to gain momentum in 2014 and this positive dynamics continued in 2015. Real GDP grew by an estimated 2.8% last year, up from 1.7% in 2014. Domestic demand growth showed small signs of recovery in 2014, but weakened again Bulgaria 2nd quarter 2016 15 in 2015, given fiscal austerity measures and the continued process of deleveraging in the private sector. Meanwhile, export growth accelerated thanks to stronger demand from some EU partners and depreciation of the euro and the lev, which helped support sales to some non-euro zone countries (all EU countries represent 62% of Bulgaria’s total exports and euro zone members 46%). Exports to Greece and Russia declined (these countries represent 6.7% and 2.4%, respectively, of total exports). At the same time, Bulgaria’s banking sector has well weathered contagion effects from the Greek crisis. Bulgaria also benefited from the greater use of EU funds, which helped stimulate public domestic demand in H2 2015. In addition to the resumption of EU payments that had been temporarily suspended, Bulgaria received “ordinary” funding from the 2014-2020 period plus “exceptional” funding from the 2007-2013 fiscal period (that had to be fully used before end-2015). 3- Credit to the private sector still down We project real GDP growth at 2.6% in 2016. Negative forces will persist, including a tight fiscal policy, the absence of recovery in credit growth, and the region’s difficulties that will still weigh on export performance. EU-funded projects are expected to remain growth-supportive, but could decline following last year’s exceptional payments. On the positive front, households should start to take advantage of lower energy prices and improving labour market conditions (the unemployment rate fell to 8.8% at end-2015). 2003 Source : IMF ■ Fiscal consolidation should continue Fiscal performance deteriorated significantly in 2014 as the result of: i) revenue underperformance and higher spending given the tense social context and anti-austerity protests of 2013, and ii) the inclusion of additional liabilities due to the need to support the Bulgarian Deposit Insurance Fund (BDIF) following the deposit run that hit two local banks in mid-20141. The 2014 fiscal deficit was finally estimated at 5.8% of GDP by the EC. As the jump in the deficit was primarily due to one-off support to the financial sector and inclusion of BDIF in the general government sector was considered exceptional, Bulgaria has not been placed under any Excessive Deficit Procedure by the EC. Moreover, the government has rapidly taken actions for fiscal consolidation. It plans to reduce the fiscal deficit each year from 2015 to 2018, on the back of stronger revenue growth (including improved tax administration) and a limited rise in expenditure (while still remaining cautious on the social spending front). The fiscal deficit fell to less than 3% of GDP in 2015 and should decline to 2.5% in 2016. In the medium term, effective reforms in the healthcare, pension and energy sectors should also help improve control of public spending and support fiscal consolidation. Government debt ratios also deteriorated sharply in 2014, rising to 27% of GDP in 2014 from 18% in 2013. This resulted from growing financing needs to cover the larger fiscal deficit and one-off items, as additional debt was issued to support the financial sector (liquidity scheme and payment of guaranteed deposits by the BDIF). The surge in debt was entirely absorbed by the issuance of new debt in foreign currency. At end-2014, 79% of government debt was denominated in foreign currency (almost exclusively euros), up from 66% in 2013. And 55% was held by foreign investors (vs. 44% in 2013). In 2015, in a stronger real GDP growth but deflationary 1 See "Bulgaria: A wave of panic”, EcoEmerging, July 2014. economic-research.bnpparibas.com █ Credit, % of GDP (lhs) ▬ Loans to corporates, annual change, % (rhs) - - - Loans to households, annual change, % (rhs) 70 120 60 100 50 80 40 60 30 40 20 20 10 0 0 -20 2005 2007 2009 2011 2013 2015 environment, the government debt-to-GDP ratio increased slightly to 30%. Similar dynamics are expected in 2016. Compared with two years ago, sovereign risk has slightly deteriorated due to the new contingent liabilities that have emerged in the banking sector and the rise in government debt ratios. However, it remains moderate and public finances still seem strong enough to absorb a shock. Sovereign risk remains supported by: still moderate government debt ratios, large fiscal reserves (about 12% of GDP), and the strong consensus on the need to maintain prudent fiscal policies. Sound public finances are a key requisite for the sustainability of the CBA, which itself is vital for sovereign solvency since government debt is mostly denominated in euros. ■ Domestic credit conditions not yet growth-supportive Under the CBA, Bulgaria’s monetary policy is tied to that of the ECB. It has been accommodative since 2009 and will remain so in the short term. The main policy rate has been close to 0% for the last three years and the nominal lending rate has decreased gradually. Due to deflation (which has been persistent since August 2013), real lending rates have increased. However, whatever the monetary policy stance, domestic credit has been driven in recent years by the continued deleveraging process in the economy, as corporates have limited their debt growth and banks have reduced their external liabilities. As a result, domestic bank credit to the private sector has barely increased since 2009 (by 0.4% per year on average). It declined as a percentage of GDP from 71% in 2009 to 59% in 2015. Domestic credit growth is projected to be close to 0% in 2016, especially as banks should remain prudent in the preparation for stress tests and the AQR. The high level of nonperforming loans (estimated at 20% of total loans in Q3 2015) remains the Achilles’ heel of Bulgarian banks. The sector’s capitalization is adequate, even though it could be dented by potential new credit losses that may arise following the AQR. The sector’s funding profile is also comfortable. While liquidity pressures remain possible, in the event of a confidence shock (like in mid2014) or as the result of the presence of Greek banks (12% of total domestic assets), the risk is lessening thanks to a strengthening in supervision. Christine Peltier [email protected] Bulgaria 2nd quarter 2016 16