This paper discusses Bulgaria’s prospects for converging to the living standards of the more advanced members of the European Union (EU). The unfavorable economic environment of the early 1990s and the economic crisis in 1996–97 hurt Bulgaria’s output, employment, and investment. Following the crisis, structural reforms and a sound macroeconomic framework set the stage for a sustained recovery. The structure of the Bulgaria economy has shifted markedly over the last decade, and investment has become the main engine of growth.

Abstract

This paper discusses Bulgaria’s prospects for converging to the living standards of the more advanced members of the European Union (EU). The unfavorable economic environment of the early 1990s and the economic crisis in 1996–97 hurt Bulgaria’s output, employment, and investment. Following the crisis, structural reforms and a sound macroeconomic framework set the stage for a sustained recovery. The structure of the Bulgaria economy has shifted markedly over the last decade, and investment has become the main engine of growth.

I. Is Bulgarias Current Account Sustainable?1

A. Introduction

1. In 2005 Bulgaria’s current account deficit reached nearly 12 percent of GDP, up sharply from the 5-6 percent range experienced in the two years immediately preceding. Deficits of such magnitude have traditionally been considered large, and thus reason to undertake policy action to correct the imbalances. However, in recent years, with the increasing integration of capital markets and the rapid development of emerging economies, a number of countries have experienced very large current account deficits that, in many instances, can be expected to persist into the future. Increasingly, research to evaluate whether such deficits are sustainable, and indeed whether they are desirable, has questioned the validity of the conventional wisdom. In Bulgaria, the speed and extent of the deterioration of the current account deficit makes such an evaluation especially timely.

2. This chapter will seek to answer these questions based on three approaches. As previously done in Leigh (2005), an estimated model of regional income convergence due to Blanchard and Giavazzi (2002) will be used to determine how much of Bulgaria’s current account deficit may be explained by a long-term catch-up process with the European Union (EU), based on the historical experience of the OECD countries, the new member states, as well as Bulgaria and Romania. Second, the implications for debt sustainability of the projected path of the current account, and the composition of its financing between foreign direct investment and debt creating flows, will be discussed. Finally, following Lane and Milesi-Ferretti (2005, 2006) the chapter will discuss the implications of the medium-term projections for the evolution of Bulgaria’s international investment position (IIP) and, thereby, for the sustainability of its current account.

3. The chapter finds that even after the recent expansion in Bulgaria’s current account deficit, its level is broadly consistent with income convergence behavior for a country with its relative GDP per capita. Similarly, with FDI at its present levels, double digit current account deficits are consistent with stable debt ratios, but given its high level, external debt will remain a not inconsiderable source of vulnerability. To offset the impact of high debt Bulgaria must continue to maintain strong policies and ample liquidity buffers. A moderately ambitious adjustment scenario could see the debt ratio fall, but remain above a level that could generally be considered “safe” for a country like Bulgaria. The adoption of the euro would alter the picture, and in this setting the projected medium-term debt levels under a broad range of scenarios could be considered “safe.” However, even under such circumstances, Bulgaria’s net IIP would deteriorate significantly, generating increasingly larger pressures on the income account. Still more ambitious adjustment will be necessary to achieve a current account position that stabilizes the net IIP.

4. The rest of this chapter is organized as follows. Section B lays out the model and discusses the results of the income convergence approach. Section C discusses the implications of Bulgaria’s large current account deficit for debt sustainability, while section D discusses the implications for the net IIP. Section E concludes.

B. Regional Income Convergence and the Current Account

5. In a world of integrated capital markets, large current account deficits are to be expected during an income convergence process. It is widely accepted that investment in lower income countries enjoys relatively higher rates of return, and in a country such as Bulgaria this is especially true in light of its sound policy framework and its imminent accession to the European Union. In this situation, economic theory suggests that capital flows to such countries help finance an increase in investment, while consumption smoothing behavior, prompted by perceived increases in future income, lead to a rise in consumption ratios. Both of these factors contribute to a deterioration of the current account deficit. Bulgaria’s experience appears to be consistent with these predictions. Nevertheless, the magnitude of the deterioration in Bulgaria’s current account deficit begs the question whether its level is at present excessive.

6. The empirical specification to address this question follows the methodology proposed in Blanchard and Giavazzi (2002).2 In particular, the current account balance (as a ratio to GDP) in country i at time t is modeled as a function of its real per capita GDP yit, relative to the average real per capita GDP for the sample as a whole, measured in logarithms. The empirical model also includes the control vector Xit, including two variables: (i) the dependency ratio, measured as the ratio of the total population to the labor force; and (ii) the real GDP growth rate. All else equal, a higher dependency ratio should lead to a worse current account balance, because of the higher share of dissavers in the economy, while the rate of growth of real GDP is included to control for the impact of cyclical factors on the current account balance. Specifically, the regression equation is as follows:3

cait=αt+βt{yit-yt}+γXit+εit(1)
A01lev2sec2

7. While the empirical specification is largely standard, the use of a time varying coefficient for the relative income variable follows Blanchard and Giavazzi (2002). They argue that financial integration has varied significantly over the last 15 years, leading to much larger movements in capital to poorer countries to finance investment and consumption. Thus, economic theory would predict that the impact of relative income differentials on the current account balance increased in recent years.

8. The sample consists of all the OECD countries (except Korea, Mexico, Turkey and Luxembourg), all the remaining new EU member countries, and Bulgaria and Romania.4 The sample period runs from 1975 to 2005, except for the recent EU accession countries, and in Bulgaria and Romania, where the sample begins in 1995.5 All of the data are sourced from the World Economic Outlook, except for real per capita GDP. For the latter, we use Heston, Summers and Aten (2002) data on PPP per capita GDP in 1996 dollars for 1975-2000, and then extrapolate the remaining years using real GDP growth rates.

9. The impact of the change in the relative income variable on the current account is plotted in Figure 1 below. The coefficients βt are statistically not significantly different from zero until the mid-1990s, but thereafter, show a marked upward shift and remain positive through the remainder of the sample. This pattern follows economic theory, inasmuch as this is a period of increasing financial integration, especially of the transition countries. The impact of differences in relative GDP on the current account deficit are also not small; the estimation results indicate that in 2005, such differences would contribute about 9 percentage points of GDP to Bulgaria’s current account deficit.6

Figure 1.
Figure 1.

Impact of Relative per capita Income on the Current Account, 1976-2005

Citation: IMF Staff Country Reports 2006, 299; 10.5089/9781451804553.002.A001

10. The estimated current account deficit from the income convergence model that also includes the control variables indicates that an appropriate current account deficit for Bulgaria in 2005 would have been 9.2 percent of GDP, below the actual 2005 current account deficit of 11.8 percent of GDP. However, because of the significant macroeconomic shocks in 2005, the results indicate that actual current account may not be out of line with the predictions of the model.7 8

Figure 2.
Figure 2.

Bulgaria: Predicted vs. Actual Current Account (in percent of GDP)

Citation: IMF Staff Country Reports 2006, 299; 10.5089/9781451804553.002.A001

11. These results are also consistent with those obtained by Hermann and Jochem (2005) in their study of the impact of relative GDP on current account deficits in the new member states of Central and Eastern Europe.9 Their model includes, in addition to relative real per capita GDP, the investment to GDP ratio and other relevant macroeconomic variables. By considering separately investment and relative income, the coefficient on the latter only picks up the impact of different consumption rates resulting from the convergence process. An analysis of the contribution to the current account deficits indicates that relative income (or different consumption rates) contributes on average about 3 percentage points to the current account deficit, while the investment rate contributes about 5 to 8 percentage points of GDP. It is also noteworthy that Bulgaria’s experience is also consistent with this result. Inspection of non-energy imports reveals that the sharp increase in recent years is, in large measure, on account of investment imports.

C. External Debt Sustainability Analysis

12. The analysis above, while useful in providing a benchmark for the level of the current account, offers few insights regarding its medium-term sustainability. The latter requires a formal debt sustainability analysis, especially important in Bulgaria where the external debt ratio (67.7 percent of GDP at end-2005) is already high in relation to internationally accepted benchmarks. This section approaches the question of debt sustainability from two different perspectives. First, it asks whether current account deficits near their present levels are consistent with a stable debt ratio in Bulgaria under different scenarios. Recognizing, however, that the present level of external debt is a significant vulnerability, it then discusses what a “safe” level of debt might be for a country in Bulgaria’s circumstances and the prospects for entering that safe zone in the medium term.

13. In what follows, it is argued that in light of the very large FDI inflows, Bulgaria can sustain current account deficits of the magnitude seen in 2005 without jeopardizing debt stability, and even with FDI at its projected medium-term level the adjustment to achieve a debt stabilizing current account balance is manageable. Over the medium term, in both the ambitious baseline scenario and an alternative scenario with little adjustment, the debt ratio declines, but stays well above “safe” levels of debt, thus raising questions about the usefulness of standard debt sustainability analysis which assume uninterrupted market access.10 In this regard, it should be noted that a key insight of the recent debt literature is that safe levels of debt are country specific. A review of the factors identified as being important in determining such a safe external debt level, and of Bulgaria’s recent record of managing its debt, its impending EU accession and eventual euro adoption, suggests that with the adoption of the euro, vulnerabilities would diminish. In turn, debt ratios under a broad range of scenarios would be consistent with notions of what might be considered safe. In the interim period, however, the high debt ratios will remain a significant vulnerability, to mitigate which Bulgaria will need to continue maintaining a high reserve cover, a low net debt ratio and strong fiscal policies.

14. The dynamics of external debt (as a percentage of GDP) are governed by the standard debt accounting equation below. It expresses the change in the external debt ratio in terms of the non-interest current account balance (tb), the real GDP growth rate (g), the rate of inflation in euro terms (ρ), the share of external debt denominated in domestic currency (α) and the nominal appreciation of the domestic currency (ε).

dtdt1=11+gt+ρt+gtρt(rtgtρt(1+gt)+εtαt(1+rt))dttbt1(2)
A01lev2sec3

15. The standard equation does not consider the role of non-debt creating inflows, which have been very important in Bulgaria during the last few years. Indeed, inflows of net non-debt creating FDI have averaged nearly 7¼ percent of GDP per year over 2003-05, and have been an important driving force behind the increase in the current account deficit, and recent indicators point to such inflows accelerating to nearly 9½ percent of GDP in 2006.11 Assuming no additions to reserves or other asset accumulation, and continued stability of the exchange rate for the leva against the euro, the baseline scenario in Table 1 indicates that Bulgaria’s non-interest current account deficit could reach 13¼ percent of GDP without adding to its external debt.12 A higher interest rate scenario shows that Bulgaria could still sustain a non-interest current account deficit of nearly 11¼ percent of GDP and still not see an increase in its debt. The “permissible” level of the current account deficit in both of these scenarios is well within the range of the realized current account deficit in 2005.

Table 1.

Debt Stabilizing Current Account Balance

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16. The two other scenarios in Table 1 highlight the importance of growth to address external vulnerabilities. In the scenario with high growth, high FDI levels and inflation closer to its medium-term average, a noninterest current account deficit of 8¾ percent of GDP stabilizes the debt level. By contrast, a low-growth adjustment path does nothing to reduce Bulgaria’s high external vulnerabilities. In such a path, an adjustment of the current account deficit associated with a significant slowdown in FDI inflows is to be expected. However, with commensurately slower real GDP growth and low inflation, the debt stabilizing noninterest current account deficit is also sharply lower at just under 3½ percent of GDP. This scenario is particularly troubling because, even an adjustment of such a magnitude does little to lower the level of external debt while, in the medium term, the country loses the beneficial effects that FDI has on productivity and growth. As noted above, Bulgaria’s current account has been largely financed by FDI, and its recent expansion influenced significantly by the growth of investment goods imports, while real GDP growth has been good. This suggests that Bulgaria’s experience largely corresponds to the “high growth” scenario in the foregoing analysis and, to that extent, mitigates concerns regarding the size of the current account deficit. It should also be noted that in Bulgaria, in light of its unfavorable demographic profile, FDI inflows are particularly important to improve total factor productivity, and hence the prospects for real GDP growth.13

17. As regards the medium term, two scenarios are considered below. In the baseline scenario, an ambitious adjustment allows the current account deficit to reach 6.9 percent of GDP by 2011.14 Although FDI is projected to remain high, albeit somewhat lower than at recent levels, the external debt ratio declines only to about 61 percent of GDP, well above safe levels in comparison with international benchmarks. In an alternative scenario in which there is much less adjustment, the current account deficit declines only to 10½ percent of GDP, and the debt ratio rises modestly to 69 percent of GDP (Table 2). Stress tests of the baseline scenario, except the exchange rate shock, indicate somewhat higher debt ratios than in the baseline, but well within the range of their current levels (Figure 3). Thus, a broad range of scenarios is consistent with relative stability of debt levels, but none of these materially addresses the key vulnerability of a high debt ratio.

Figure 3.
Figure 3.

Bulgaria: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2006, 299; 10.5089/9781451804553.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2006.
Table 2.

Bulgaria: Medium-term Debt Profiles in the Baseline and Alternative Scenarios

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18. While international benchmarks provide useful “rules of thumb” for analyzing external debt vulnerabilities, recent studies of debt sustainability have emphasized country specific characteristics as being more important than overall debt burdens. Two key concepts identified in the literature, “debt intolerance” and “original sin,” have been particularly influential in shaping the debate on debt issues. In particular, debt intolerant countries, or countries afflicted by original sin, may suffer frequent interruptions of their access to capital markets, leading to discrete jumps in interest rates or sharply higher debt ratios contingent on an exchange rate depreciation. In these circumstances, conclusions of simplistic debt sustainability exercises are not meaningful and, hence, a determination as to whether Bulgaria belongs to these categories is warranted.

19. Reinhart, Rogoff, and Savastano (2003), henceforth RRS, argue that a country’s record of meeting its debt obligations and managing its macroeconomy in the past is relevant to forecasting its ability to sustain moderate to high levels of indebtedness, both domestic and external, many years into the future. Thus, they introduce the concept of debt intolerance, which manifests itself in the extreme duress that many emerging market economies experience at overall debt levels that would seem quite manageable by the standards of advanced industrial economies. These can be as low as 15-20 percent of GNP in many cases, and the thresholds depend heavily on the country’s record of debt and inflation. Debt-intolerant countries tend to have weak fiscal structures and weak financial systems, and default tends to exacerbate these weaknesses. RRS suggest that a country’s current level of debt intolerance can be approximated empirically as the ratio of the long-term average of its external debt (scaled by GNP or exports) to an index of default risk. They also note that debt intolerant countries very rarely achieve significant reductions in their debt burden without some kind of adverse credit event. In what follows, both of these factors are considered in trying to determine Bulgaria’s level of debt intolerance.

20. An analysis of this nature for Bulgaria is complicated by the very short span of time in which it has been properly integrated into international capital markets. That said, the period before 1998 appears not to be very relevant to the analysis at hand, and even after that, a decision by the EU to announce a firm schedule for accession appears to have marked a structural break in terms of the country’s access to international capital markets.15 Accordingly, data for the period 2003-05 are considered, noting however that RRS base their calculated benchmarks on data for the period 1979-2000.

21. The methodology proposed by RRS proceeds in two steps: (1) classifying a country into a debt intolerance club based on its International Investor Rating; and (2) further partitioning the club of countries with intermittent access to capital markets, based on their level of debt intolerance. As indicated below, Bulgaria would be classified as a Region II “quasi debt intolerant” country under this scheme.16

uA01fig01

Borrowing Countries

Citation: IMF Staff Country Reports 2006, 299; 10.5089/9781451804553.002.A001

22. RRS also propose an indicator to measure a country’s debt intolerance along a continuum, namely the average level of external debt, scaled by GNP or exports, as a ratio of the average IIR. Comparing this indicator for Bulgaria with emerging market countries identified in RRS as being the least debt intolerant (i.e. no recorded default) and others with at least one default suggests that Bulgaria may lie somewhere between these groups. This is especially the case when debt is scaled by exports. On these bases, Bulgaria would be classified as a Region II country.

23. Many studies have emphasized that credit ratings are unpredictable and can change without warning. Thus, the short history of ratings that the foregoing analysis relies on is an obvious weakness and warrants investigating whether Bulgaria’s recent ratings reflect idiosyncrasies of financial markets, or if there are more fundamental factors that might reflect the shift in market sentiment. In what follows below, it is suggested that Bulgaria’s recent record of debt reduction and impending EU accession are factors that have offset the effect of a high external debt ratio on its debt intolerance.

24. RRS note that debt intolerant countries rarely achieve a significant reduction of their debt burden outside of an adverse credit event, and following such an event, governments in emerging market countries often quickly amass debt once again, leading to the re-emergence of the symptoms of debt intolerance. They define large debt reversals as episodes where countries were able to lower their external debt burden by 25 percentage points of GNP or more. Moreover, they restrict their sample to cases where over the 3-year period, average growth was at least 5 percent, or where the nominal dollar value of debt declined by at least 10 percent. Of the 22 such episodes they identify during 1970-2000, only 7 debt reductions were achieved outside of an adverse credit event, and in 6 of these cases the reduction was aided by large repayments, although output growth also contributed in 5 of these cases. In only one case, Swaziland, was a country able to achieve a large debt reduction only on account of growth. In recent years, strong macroeconomic policies have allowed Bulgaria to achieve a “significant debt reduction” along the lines defined by RRS.17 Over the period 2001-03, Bulgaria’s gross external debt declined by 26 percentage points of GDP, including a reduction in euro denominated debt by 10½ percent, while average real GDP growth averaged 4½ percent, also close to the threshold identified by RRS (Table 3).

Table 3.

Bulgaria: Record of Debt Reduction

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Source: Bulgarian authorities; and Fund staff estimates

25. Impending EU accession is also probably an important factor influencing favorably market perceptions of Bulgaria. While not a formal part of their investigation, RRS recognize that external political anchors such as the EU help countries shed debt intolerance faster than they may otherwise have done. Indeed, they cite the examples of Greece and Portugal as the frontrunners among the possible candidates to graduate from Club B to Club A. Based on data averaged over 1992-2000, their regressions predict both countries to be in Region IV, whereas their actual ratings over this period place them in Region II. The evolution of the IIR ratings for Bulgaria and Romania also show a distinct jump in 2004, roughly the period when the parameters, including possible timing of EU accession, were finalized, thus supporting the hypothesis regarding the importance of such an external anchor.

26. In addition, Bulgaria’s liquidity indicators are very strong. In particular, it has ample reserves, and such reserves are expected to more than fully cover the stock of short-term debt over the medium term.18 Bulgaria’s strong reserves are also reflected in its low net external debt ratio. Finally, Bulgaria has adopted a very strong fiscal policy stance that has permitted a continual reduction of its public debt ratio (Tables 4 and 5).19

Table 4.

Bulgaria: Key Vulnerability Indicators

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Table 5.

Gross Debt of the General Government, 2001-2005

(in percent of GDP)

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Source: World Economic Outlook

27. Nevertheless, the level of Bulgaria’s external debt is beyond most conventional estimates of a “safe” debt threshold, and although recent research has increasingly sought to identify combinations of factors that increase the risk of crises, the vulnerability from this source should not be discounted, at least not until Bulgaria is granted entry into the eurozone. How a development such as euro adoption would help reduce vulnerabilities is discussed in the debt literature on “original sin.”

28. Eichengreen, Hausmann and Panizza (2003), hereafter EHP, define original sin as a country’s inability to issue debt in its own currency. They note that while original sin may be related to other factors such as institutional or policy weaknesses, in too many instances, even with strong policies and institutions, emerging markets suffer from original sin. EHP take issue with RRS’s conclusions that the history of debt service is critical to determining whether developing countries are less able to manage debts that are manageable for advanced economies. While EHP accept the basic insight that history matters, their empirical work demonstrates that when the models studied by RRS are modified to include measures of original sin, the impact of debt ratios on credit worthiness ratings are no longer different for advanced and emerging market countries. They conclude that while debt ratios are an important determinant of credit worthiness, it is original sin that distinguishes advanced economies from emerging markets.

29. This finding has important implications for Bulgaria. At present nearly 75 percent of Bulgaria’s external debt is denominated in euros, with most of the balance in US dollars. While the currency composition of its debt is a significant vulnerability at present, on euro adoption Bulgaria will have shed original sin. Moreover, the expectation that this will happen is an important component in containing the risk associated with its high debt ratio or, in RRS terminology, making it less debt intolerant. This intuition is also confirmed by the stress tests shown in Figure 3 (at the end of the chapter). As noted above, they indicate a modest impact on debt levels for all of the shocks, except that related to the exchange rate, under which debt levels would climb sharply to nearly 90 percent of GDP, making untenable the assumption of uninterrupted access to capital markets underlying the debt sustainability analysis.

30. The discussion above is silent on what level of external debt would be safe for a country like Bulgaria once it has shed original sin. As mentioned earlier, recent research seeks to identify combinations of factors that influence the potential for crises, and application of such regression tree analyses point to a low risk of a crisis in Bulgaria even in the period prior to euro adoption.20 Additionally, as noted above, Bulgaria’s high export-GDP ratio, averaging nearly 56 percent over 2002-05, also helps lower its risks. In light of these factors, especially when taken in conjunction with the strong observed connection between currency crises and defaults in emerging markets, the present external debt ratio in Bulgaria would be manageable in a post euro adoption phase.21

31. The results in EHP also downplay the likely importance of the external debt ratio following formal euro adoption. EHP’s analysis suggests that after controlling for original sin, it is public debt (as a ratio to GDP or to revenues), and not the external debt ratio, that is the relevant variable in explaining a country’s access to capital markets.22 Bulgaria’s public debt ratio was nearly 32 percent of GDP at end-2005, and is projected to decline further to less than 19 percent in the medium term. These ratios are low, especially in comparison to the 60 percent of GDP criterion enshrined in the Stability and Growth Pact. Bulgaria’s public debt ratio also compares favorably with the public debt ratios of the EU15, all of whom enjoy easy access to international capital markets (Table 5).23

32. Some caveats to the analysis above may, however, be in order. Countries not afflicted by original sin in EHP’s sample consist mainly of industrial countries. Confidence in such countries, associated with the shedding of original sin, has evolved gradually. Would markets treat the new accession countries adopting the euro in the same way as others that have shed original sin? Eliminating exchange risk would address an important vulnerability for Bulgaria, and also for its mainly European debt holders. Both of these reasons ought to allow continued access to capital markets, even during economic downturns. In addition, membership in the EU would provide greater confidence regarding the maintenance of sound policies. Nevertheless, only time will tell if these factors will in fact, in the future, allow new eurozone members to have similar market access as the industrialized countries. In the meanwhile, it would not be unreasonable to conjecture that markets might initially hold these countries to a higher standard than industrialized countries. This would suggest that even after euro adoption, continued maintenance of strong policies, and liquidity buffers, especially to guard against the possible risk that some private liabilities may become socialized, remains important.

D. A Net International Investment Position Perspective

33. In the previous sections, it has been argued that the large volumes of FDI are an integral part of the transition experience, and in Bulgaria have helped it sustain current account deficits that would, in other circumstances, have a significantly adverse impact on its international indebtedness. However, such investments necessarily entail a deterioration of the income balance on account of growing profit transfers back to the source country. Thus, improvements in the remaining items of the current account will be needed to offset these payments, and additionally, the decline in FDI as convergence progresses. Following Lane and Milesi-Ferretti (2006), LM-F hereafter, the extent of the needed adjustment can be estimated from calculations of the net IIP stabilizing level of the current account balance excluding net income and interest (henceforth “adjusted current account balance”.)

34. Following LM-F, the change in the net IIP may be expressed as follows:

btbt1acabt+rtEQAgt1+gtat1EQ+rtDAgt1+gtat1D+rtEQLgt1+gtlt1DrtDLgt1+gtlt1D+εt(3)
A01lev2sec4

where the superscripts EQ and D identify debt and equity components of external assets and liabilities, as well as their respective rates of return, r, denotes the real rate of return at time t, gt the growth rate at time t, at-i and lt-1 the stock of assets and liabilities at the end of period t-1, respectively, and acabt the adjusted current account balance at time t.

35. As noted above, Bulgaria is expected to enjoy high levels of FDI over the medium term which would finance relatively large current account deficits. Accordingly, over this period it would be natural to expect the net IIP to deteriorate further.24 Thus, in what follows, the focus is on the net IIP in 2011 that is consistent with the baseline medium-term balance of payments projections. For the other variables, the assumptions of LM-F as described below are adopted:

  1. Output growth of 6 percent is assumed, consistent with staff’s baseline projections for 2011. This is also a rate of growth that can be sustained in the medium-term.

  2. For FDI and portfolio equity investment in the country, LM-F assume that the real rate of return will move in line with the rate of growth of the country, reflecting the risk sharing properties of equity investment—if the country does well investors enjoy a higher return and vice versa. For simplicity, a constant spread of 100 basis points is used in the calculations.

  3. For foreign debt liabilities, the rate of return is assumed to be equal to the projected interest rate on long-term bonds in the euro area, plus a spread of 150 basis points. This spread is somewhat higher than the present spread on assets originating in Bulgaria, but given that the global financial situation at present is exceptionally benign, a somewhat higher spread appears to be a realistic assumption.

  4. For FDI and portfolio investment abroad, the rate of return is assumed to exceed the world growth rate by 100 basis points, for reasons analogous to those mentioned for FDI inflows.

  5. Finally, the rate of return for debt assets abroad is assumed to be equal to the projected interest rate on euro bonds.

36. Table 6 contains information on the evolution of the net IIP in Bulgaria under the baseline and alternative scenarios. As anticipated, these indicate a sharp deterioration in the net IIP over the medium term, from about 31 percent of GDP in 2005 to nearly 63 percent of GDP in 2011 under the baseline scenario, and still further to 72.6 percent of GDP in the alternative scenario. Net IIP positions of this magnitude are large by historical comparisons, although to be expected with greater financial integration and the economic transition underway in Bulgaria. The data reported by LM-F indicate that half of the CEE countries had net IIP deficits at roughly such levels or higher already in 2004. Nevertheless, it is also clear that a deterioration in the net IIP cannot proceed indefinitely and that changes in the adjusted current account needed to stabilize the net IIP could be substantial.

Table 6.

Bulgaria: Net International Investment Position

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Source: Bulgarian National Bank; and Fund staff estimates.

Stabilization at 2011 net IIP ratios.

37. Table 7 indicates that to stabilize the net IIP at its 2011 level under the baseline scenario would require a surplus of 1¼ percent of GDP in the adjusted current account. Under this ambitious scenario, the adjusted current account is projected to improve only to a deficit of about 2 percent of GDP (from a deficit of nearly 9 percent of GDP in 2005). To achieve the net IIP stabilizing level of the adjusted current account deficit, annual real export growth would have to be on average nearly 1½ percent higher even with no further increase in import growth rates. This represents a considerable challenge, especially as real export growth is projected to average 11¾ percent over 2006-2011 under the baseline scenario. Under the alternative scenario, the challenge is greater still. The adjusted current account improves only to a deficit of 5 percent of GDP by 2011, and to achieve the adjusted current account balance that stabilizes the net IIP, annual real export growth would have to be on average about 2¾ percent higher.

Table 7.

Bulgaria: Baseline and Alternate Adjustment Scenarios

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This is the adjusted current account that stabilizes the net IIP at the 2011 level.

E. Conclusion

38. In conclusion, we find that current account deficits of the magnitude seen recently in Bulgaria are not necessarily unsustainable. Large current account deficits at this stage of Bulgaria’s transition process are to be expected, especially in light of the large FDI inflows, by which they are also being financed. However, in light of Bulgaria’s high external debt, vulnerabilities until adoption of the euro will remain considerable, and sound policies, as well as continued high levels of reserves needed to send the appropriate signal to financial markets, will be particularly important. Finally, the discussion on net IIPs points to the continued importance of sound policies for some time to come in order to achieve a turnaround in the current account position. Accordingly, euro adoption should not be seen as a time at which complacency can set in on the policy front.

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  • Reinhart, C. M., K. S. Rogoff, and M. A. Savastano, 2003, “Debt Intolerance,” NBER Working Paper No. 9908.

1

Prepared by Bhaswar Mukhopadhyay.

2

Leigh (2005) applies the same methodology, among others, to determine the appropriate level of the current account deficit for Lithuania.

3

Lagged values of the current account are also included in the right hand side of the equation to control for autocorrelation.

4

As explained in Blanchard and Giavazzi (2002), the impact of their respective financial crises on the current account dynamics in Korea, Mexico and Turkey probably swamp the impact of the income convergence process. In Luxembourg, persistently large measured current account surpluses, in the range of 10-15 percent, appear to be highly idiosyncratic.

5

The equation is estimated using least squares for an unbalanced panel.

6

Since the set of regressors includes the lagged dependent variable, the current account is affected by both, the contemporaneous and the lagged values of relative GDP.

7

See Bulgaria—Second Review Under the Stand-by Arrangement and Requests for Waiver of Performance Criteria and Postponement of Third Review (EBS/06/39).

8

The estimated current account balance also lies within the 95 percent confidence interval, although in light of the rather wide bands, the implications of this should be considered with caution.

9

They consider GDP relative to Germany.

10

Reinhart, Rogoff, Savastano (2003) argue that a safe level of debt should not exceed 35 percent of GDP, with nearly half the countries in their sample with debt ratios below this level having sound credit histories. Using an entirely different methodology, IMF (2002) suggests that an external debt-to-GDP ratio of about 40 percent is a useful benchmark. For countries with debt ratios below this level, the conditional probability of a crisis is 2 percent, rising to 15-20 percent for ratios above this level. However, the probability of default declines sharply after conditioning for exports as a ratio to GDP; for such ratios exceeding 40 percent, the conditional probability of default is found to be 5 percent even when the gross external debt ratio exceeds 65 percent of GDP, albeit based on a very small sample that limits the robustness of this conclusion. In Bulgaria, the ratio of exports of goods and services to GDP averaged nearly 56 percent over 2002-05, a testament to its open economy, even after noting that a number of important exports (textiles, metals, and fuels) have significant import requirements.

11

The average for 2003-05 excludes the impact of a single large transaction that raised debt by nearly 5 percentage points of GDP and lowered net FDI by 3 percentage points of GDP.

12

Additions to gross reserves or other external assets would lower the gross debt-stabilizing level of the current account balance, but have no impact on its net debt-stabilizing level. While the distinction between gross and net debt is meaningful in a discussion of sectoral vulnerabilities, and attendant balance sheet effects, they are not relevant in the present context.

13

The chapter on “Bulgaria’s Growth and Convergence Prospects” discusses this issue in greater detail.

14

The adjustment is aided by an increase in annual EU transfers of about 2½ percentage points of GDP.

15

The discussion on original sin below provides some indications how the anchor of EU accession can influence access to capital markets.

16

The Regions I-IV are graded according to the level of debt intolerance from relatively “safe” countries (region I) to more precarious countries (regions III and IV).

17

The analysis here is in terms of ratios to GDP and euro denominated gross debt, rather than ratios to GNP and dollar denominated debt in RRS.

18

Many studies conclude that the ratio of reserves to short-term debt external may be the single most useful indicator of whether a given size current account deficit or external debt may be a cause for concern. The Guidotti “rule (of thumb)” says that the probability of a crisis rises when the ratio of short term external debt to reserves exceeds one. Frankel and Wei (2004) discusses some of these issues in a useful review of the literature on macroeconomic crises.

19

RRS especially note the importance of maintaining low public debt levels for debt intolerant countries.

20

Application of the tree in Manasse and Roubini (2005) to Bulgaria’s circumstances produces a crisis probability of 2 percent, as demonstrated in IMF (2006b). Similarly, Bulgaria would fall in the lowest risk category even in the regression tree analysis done by Frankel and Wei (2004).

21

Reinhart (2002) finds a strong link between currency crises and defaults in developing countries; about 85 percent of all defaults in the sample are linked with currency crises.

22

In most of their equations the external debt ratio is no longer significant, and it also always enters with the wrong sign. RRS also find that the coefficient on external debt (as a ratio to GNP) for countries in Club A is not significant.

23

EHP also find that the level of development, measured by the logarithm of GDP per capita, positively affects a country’s credit rating. However, since the coefficients on the debt ratio and on the logarithm of GDP per capita are of a broadly similar magnitude, Bulgaria’s per capita GDP would have to be significantly lower than even its present low level to materially offset its very low public debt ratio.

24

This is also consistent with the observed evolution of net IIPs in a number of other CEE and Baltic countries, many of which have net IIPs that are considerably more deteriorated than Bulgaria.

Bulgaria: Selected Issues and Statistical Appendix
Author: International Monetary Fund