Risk drivers and outlook

Bulgaria is slowly recovering from the disruption brought by the global financial crisis in 2009 and the local banking crisis in 2014. However, growth accelerated in 2015, thanks to the better performance of the exports sector and the considerable boost from public investment, driven by EU financing. Although the latter is expected to slow down this year, private consumption and net exports should take over. Growth is expected to be at a fair 2.3% in both 2016 and 2017. Nonetheless, there has been no recovery in terms of credit growth, reflecting both supply and demand-side constraints, as corporates are suffering from high indebtedness weighing on private investment. Persistent deflation is also putting pressure on the profitability of non-financial corporates and their ability to deleverage. Generalised corruption and a poor rule of law are hampering the business environment. All in all, our category for the commercial risk assessment is B on a scale of A-C. Credendo Group’s short-term political risk classification for Bulgaria, representing the country’s liquidity, is in the lowest risk category (1 out of 7). This positive evaluation is largely determined by Bulgaria’s membership of the European Union (EU), which prevents the imposition of (long-term) capital controls within the Union and enables the control of macroeconomic balances. Positive internal factors, such as a good level of foreign exchange reserves, well above the short-term external debt, strengthen our positive view. The medium- to long-term assessment of the political risk (category 4 out of 7), representing the country’s solvency, remains negatively impacted by the rather high level of external debt, though on a decreasing path (in absolute and relative terms). The large reduction in the fiscal deficit, the absence of major external vulnerabilities (the country has registered a current account surplus since 2013), substantial buffers in place in the framework of the currency board and limited exposure to international capital markets protected the country against last year’s wave of capital outflow from emerging countries. Recurrent episodes of political instability have not hindered those positive adjustments, although this factor is certainly a stumbling block for more structural reforms, which are needed to enable Bulgaria to catch up with the level of income of other EU countries.

Facts & figures

Pros

  • Sound public finances
  • Export surge and current account surplus
  • Good liquidity position
  • Availability of EU Cohesion and Structural Funds

Cons

  • High gross external debt
  • Poor business environment
  • Political instability
  • Demographic and educational weaknesses

Main export products

  • Travel services (10% of current account receipts), fuels (9.4%), copper and articles thereof (6.9%), electrical machinery (6.3%)

Income group

  • Upper middle

Income per capita

  • USD 7,420

Population

  • 7.2 m

Description of electoral system

  • Presidential: 5-year term, next elections in October 2016
  • Legislative: 4-year term, next elections in October 2018

Prime Minister

  • Boyko Borissov (GERB)

Head of State

  • Rosen Plevneliev

Country risk assessment

Slow transition to a market economy

Bulgaria’s transition to democracy and a market economy since the end of Communism has been slow and painful. The influence of former Communists remained strong at the beginning of independence from the Soviet Union’s orbit and there was little progress towards economic reform in the 1990s. When Simeon II, Bulgaria’s former king, was prime minister between 2001 and 2005, the country made good progress with market reforms designed to meet EU economic targets. It then achieved sustained growth, unemployment fell (though still reaching 10% in 2005) and inflation was brought under control. Nonetheless, living standards remained low as income distribution remained a serious problem. Graph_Bulgaria_1EN Bulgaria was not among the first wave of central and eastern European countries entering the EU in 2004 but joined only in January 2007. Although the EU authorities had set tough entry requirements in terms of corruption and organised crime, failures in that respect led the EU to (temporarily) suspend aid worth hundreds of millions of euros in 2008. Joining the Schengen visa-free travel zone is also currently conditional on the achievement of ‘irreversible progress’ in the fight against corruption and organised crime and in judicial reforms. The country has been a member of NATO since 2004, joining at the same time as seven other former socialist countries.

Recovery after the slump

The 2008-09 financial crises interrupted the sustained growth the country had been registering since the beginning of the decade. Having benefitted from real GDP growth of 6% on yearly average between 2000 and 2008, it registered a low 0.9% on average between 2010 and 2014. It was only in 2015 that growth accelerated (+3% estimated) thanks to the good performance of the exports sector and the considerable boost from public investment. With a non-negligible share of exports going to non-euro countries, it benefitted last year from the low value of the euro, to which its currency is pegged. Indeed, Bulgaria’s main export partners for goods are Germany, Italy, Turkey, Romania and Greece. Moreover, with just 4% of exports of goods and services going to Russia, it is only slightly impacted by the recession there. Besides services such as travel and transport, Bulgaria exports mostly refined fuels, electrical and electronic equipment, copper and articles thereof. Growth last year benefitted from the boost in public investment thanks to the use of EU Cohesion and Structural Funds, which served as co-financing. This boost was due to the necessary use of the remaining funds under the previous 2007-13 financing cycle and is consequently not expected to continue at such a pace this year. As for private investment, it remains dragged down by an unsupportive business environment. The outlook for 2016 and 2017 is a slowdown in growth, mainly explained by the reduced availability of EU funds in comparison to last year. On the other hand, private consumption, which remained subdued in 2015 in spite of the low inflation because of the narrow wage growth and less expansionary fiscal position, could well strengthen. Exports should also be supported by higher demand from the EU (representing almost 60% of goods exports) and by the depreciated euro, resulting in positive contributions of net exports to economic growth. The IMF forecasts real GDP growth of 2.3% in both 2016 and 2017.

Financial sector under reform after the bankruptcy of the fourth largest bank in 2014

In May 2014, the country’s fourth largest bank (and second largest domestically owned bank) KTB faced a bank run and liquidity strains that forced it to go bankrupt. The event followed internal mismanagement and quarrels between the principal stakeholder of the bank and one major borrower, a controversial MP and businessman, revealing illicit collusion among the political and economic elite. In the aftermath of this bank run, the largest domestic bank (First Investment Bank) was also subject to massive withdrawals from depositors, fed by supposedly false rumours, illustrating more globally the absence of confidence among Bulgarian citizens in the management of their financial institutions. A lack of efficient supervision of the financial sector was also pointed to as a factor in the crisis. Fortunately, the rest of the banking system, mainly foreign owned, was well capitalised and liquid and those events did not represent a systemic risk for the entire sector. However, the European Commission opened a credit line of EUR 1.7 bn at the time to improve the liquidity of the Bulgarian banks as a precautionary measure. In the meantime, confidence in the sector has been restored and the liquidity and profitability of the whole system have increased, in spite of large disparities among entities. This positive evolution results from the adoption by the authorities of a set of wide-ranging financial sector reforms. Changes in banking sector legislation and positive developments in banking supervision have been initiated, notably in response to the weaknesses identified by the joint IMF/World Bank Basel II Core Principles assessment. A comprehensive asset quality review and stress test of the entire banking sector has been launched in cooperation with European institutions, the results of which will be published in the second half of 2016. Nonetheless, challenges remain, such as improving the efficiency of insolvency procedures and solving enduring asset quality problems, in particular due to the resilience of cronyism practices. An increased preference from depositors for larger foreign banks at the expense of domestic or Greek-owned ones indicates increased risk awareness. Moreover, in view of the significant share of Greek bank subsidiaries operating in Bulgaria (about 20% of the sector’s assets), divestment from the parent banks could pose severe threats to the economy. High indebtedness of the non-financial corporates sector represents another threat to the banking sector and other creditors. Bulgaria’s non-financial corporate sector debt, representing about 100% of GDP in 2014, is among the highest among the new EU Member States. The liabilities surged during the pre-crisis boom and have declined only modestly since 2008. This debt servicing risk is now exacerbated by negative inflation, which is putting pressure on the profitability of non-financial corporates and is not helping them to deleverage. The construction and real estate sectors might still be additionally impacted by the collapse in asset prices which happened during the 2009 crisis, as those sectors contributed largely to the pre-crisis increase in indebtedness. According to the European Commission, ‘the industries facing the highest debt sustainability risks include construction, real estate, hotels and restaurants and other business services.’ The debt of the public electricity supplier NEK is also nearing 4% of GDP and financial problems have become more acute with the social pressure regarding rising electricity prices. Despite promising financial reforms, credit growth is failing to recover. Corporate credit growth has been flat since 2010 and even declining since the 2014 banking crisis, reflecting both supply and demand-side constraints. Disincentive measures have been introduced by the central bank for banks to hold excess cash reserves but weak economic activity and corporate deleveraging efforts amid high corporate indebtedness have curbed demand.

Monetary policy constrained by the currency board

The currency board (an exchange rate that is fixed to an ‘anchor currency’, with automatic convertibility between the domestic and anchor currencies) which defines the Bulgarian exchange rate system requires the conventional objectives of the central bank to be subordinated to the exchange rate target, i.e. the peg to the euro. This arrangement has been in place since 1997 (first with an anchor to the Deutsche Mark), when it emerged as a solution to the problems of near hyper-inflation, excessive central bank lending to banks and extremely high interest rates on government debt. Indeed, under a currency board, the country loses its monetary policy tools and inflation and real interest rates near those of the anchor currency. It rapidly appeared that the move was efficient in restoring confidence in the currency and macroeconomic stabilisation followed. It is often credited as being the basis of the economy’s subsequent enduring stability. More recently and since mid-2013, inflation has been persistently negative. Deflation began amid a protracted low-growth environment and has persisted, mainly owing to sharply lower energy and commodity costs and reductions in administered prices. The currency board restricts the scope of the monetary policy to tackle deflation. Nonetheless, inflation is forecast to exit negative territories in the course of the year. For such a currency arrangement to be credible, the central bank must hold official foreign exchange reserves above the level of the entire narrow money supply. The holding of foreign exchange reserves has always been adequate and large.

Macro imbalances largely corrected

The maintenance of sound macroeconomic policies is of primary importance under a currency board as they contribute to the accumulation of foreign exchange reserves. In addition to the foreign exchange reserves resulting from balance-of-payment transactions, a fiscal reserve was set up in 1997 at the inception of the currency board. Its minimum amount was originally fixed at the level of debt payment over the following year. However, it has often been much larger than that requirement, fed by booming fiscal surplus and privatisation in the mid-2000s, which largely helped to finance the fiscal deficits after the 2009 crisis. The deficits remain but have mostly been moderate thanks to a fiscal commitment by successive governments. Only in 2014, a fiscal slippage and a substantial increase in public debt in terms of GDP were registered, mostly explained by the liquidity scheme for the stabilisation of the financial sector after the bankruptcy of KTB. It increased the fiscal deficit to 3.6% of GDP for that year, while this deficit was reduced to 2.9% in 2015. But fiscal consolidation is still planned for the next two years and is expected to continue reducing the fiscal deficit. In spite of an increase of 9 percentage points in terms of GDP in 2014, the level of public debt (26.9% in 2015) remains well below the Maastricht criteria and is the third lowest in the EU (after Estonia and Luxemburg). On the external balances side, a current account surplus has again been registered since 2013 thanks to a surge in exports following large deficits in the aftermath of the global financial crisis. In 2015, the surplus was estimated to have increased to 2.1% of GDP, also on the back of lower international energy prices and fiscal consolidation constraining imports. The structural improvement in the current account has contributed to scale down gross external debt, although it is still elevated (88% of GDP in 2015), in particular for non-financial corporates. However, this reduction has come mainly from a reduction in short-term debt up to 2014, partly thanks to lower reliance by commercial banks on financing from their foreign parent banks. The absence of major external vulnerabilities, substantial buffers in place in the framework of the currency board and limited exposure to international capital markets have protected the country against last year’s wave of capital outflow from emerging countries. Graph_Bulgaria_2EN

Corruption and unsupportive business environment impeding investment

Macroeconomic imbalances (observed mainly on the external side) have decreased since the crisis and the financial sector is in the process of being strengthened. But other structural weaknesses are contributing to keeping the country risk premium and thus the cost of capital high in the economy, weighing on private investment and thereby on the potential for growth. First of all, the business environment as a whole remains unsupportive. The World Bank Doing Business 2016 indicators (assessing ‘how easy or difficult it is for a local entrepreneur to open and run a small to medium-size business when complying with relevant regulations’) rank Bulgaria in 38th position, behind Poland, Slovakia, the Czech Republic and Romania but ahead of Croatia and Hungary. The country performs the worst on the ‘paying taxes’ indicator, due to the administrative burden of paying taxes and contributions (the flat corporate income tax rate of 10% is on the contrary very business friendly), and the ‘getting electricity’ indicator. But bureaucracy and corruption are often cited as the main hindrances to doing business. According to a study by the European Commission, ‘61% of private sector managers in Bulgaria say that corruption is a problem for them when doing business, compared to an EU average of 40%. Nearly 60% of companies, the highest percentage in the EU, say that corruption prevented them from winning a public tender or public procurement contract (up by 2 percentage points since 2013). Only 14% (the lowest percentage in the EU) say that Bulgaria applies measures against corruption impartially (down from 23% in 2013).’ The authorities are very slow to tackle the matter and are hindered by weak institutions. An unstable policy and regulatory framework, concerns about the independence, quality and efficiency of the judicial system and protracted insolvency procedures are also obstacles to investment. Graph_Bulgaria_3EN

Education and demographic trends curtailing medium-term growth

The public procurement system suffers from long-lasting weaknesses which limit the use and efficiency of the European Structural and Investment Funds. Under the current 2014-20 programme, Bulgaria is entitled to EUR 7.6 bn (18% of 2014 GDP) in EU regional and cohesion policy funds. The absorption rate of those funds is not optimal since Bulgaria absorbed only 85% of the EU funds available under the 2007-13 financing cycle, below the EU average (89%) and placing the country 22nd in that respect. With a higher rate of absorption and efficient use of those funds, the potential for growth could be increased substantially, enabling the country to catch up quicker with the other European economies. The quality of education and training and their inadequacy with respect to the requirements of the labour market continue to hamper the supply of skilled workers (IT workers, engineers, specialist doctors, nurses), again weighing on investment in some sectors. The positive correlation between the socioeconomic background and educational performance of pupils is particularly strong in Bulgaria. With poverty and inequality levels being among the highest in the EU, human capital development is hindered. Significant outward migration is not helping to solve the labour market inadequacy. The population has decreased by 20% in one generation, due equally to the natural (birth) change and to outward migration (partly explained by a brain drain), which represents one of the largest contractions in the world. This trend is forecast to continue. Refugee influx is not expected to compensate for this trend, since people escaping war zones in the Middle East consider Bulgaria more as a place of transit rather than a settlement country.

Political instability preventing the adoption of badly needed reforms

The presence of many small parties makes the Bulgarian political scene highly fragmented, as illustrated by the current division of the country’s parliament between eight parties. There is also an evident lack of confidence among the population in the political system in general, which is allegedly corrupt. Large protests in that respect, amid the banking scandal, were at the origin of the collapse of the previous government in June 2014. Contrary to the current trend in Romania, where a crackdown on high-level political corruption is in place, the Bulgarian political scene is still tainted by nepotism and dubious practices. In September 2015, a much-advertised reform to set up a Romanian-style special agency to investigate corruption cases did not go through parliament, as lawmakers feared it could lead to a witch-hunt by prosecutors. Also, last February and March, a series of public tenders and contracts were suspended by the Prime Minister (in the defence, infrastructure, tourism and construction sectors) and by the transport minister (in internet networks and railway infrastructure). Suspected irregularities and lack of transparency in the selection procedure were invoked as reasons for the halts. The government’s willingness to distance itself from member of parliament and businessman Delyan Peevski, who was at the origin of the KTB bank collapse and to whom most projects were indirectly linked, is another possible explanation. The current ruling coalition consists in a minority government composed of the centre-right Citizens for European Development of Bulgaria (GERB) party, which won the last elections in October 2014, in alliance with its most logical partner, the rightist Reformist Bloc (RB). The GERB-RB, which fell short of a majority, must count on the support of two additional parties, the leftist ABV party and the nationalistic Patriotic Front (PF), to pass laws. The alliance has been shrinking since it took office, as one party constituting the RB, namely Democrats for a Strong Bulgaria (DSB), withdrew its support for the government in December 2015, after the latter unexpectedly failed to back the bill of constitutional amendments related to the much-debated judicial reform, adopting a softer stance. Last February, the coalition defeated its first no-confidence vote, called by the opposition, unsatisfied with the handling of the healthcare reforms aimed at streamlining the cash-strapped, inefficient healthcare system. The country obviously remains at risk of snap elections due to the lack of a majority government. Nonetheless, the government is resolutely pro-business and aims to further improve the business climate and foster FDI, in particular in the IT and outsourcing, high technology, automotive and innovative industries and the pharmaceutical, biotechnology, electronics and e-commerce sectors.