Bulgaria
2007 Article IV Consultation-Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Bulgaria
Author: International Monetary Fund
Publication Date:
19 Dec 2007
eISBN:
9781451804577
Language:
English
Keywords:
ISCR; CR; authority; saving-investment imbalance; EU accession; deficit; surplus; GDP deflator; absorption boom; net IIP; market share; Fiscal stance; Current account deficits; Global
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This 2007 Article IV Consultation highlights that Bulgaria’s large external imbalance has continued to widen. Driven by massive capital inflows, particularly foreign direct investment inflows, the current account deficit could reach a record level of 20 percent of GDP in 2007. Although the present level of the current account deficit is clearly above sustainable levels, external competitiveness has remained adequate. Bank credit has again started to expand rapidly after the administrative credit limits imposed during 2005–06 lapsed.

Abstract

This 2007 Article IV Consultation highlights that Bulgaria’s large external imbalance has continued to widen. Driven by massive capital inflows, particularly foreign direct investment inflows, the current account deficit could reach a record level of 20 percent of GDP in 2007. Although the present level of the current account deficit is clearly above sustainable levels, external competitiveness has remained adequate. Bank credit has again started to expand rapidly after the administrative credit limits imposed during 2005–06 lapsed.

I. Overview

1. The first Article IV Consultation following EU accession took place amid growing concerns about Bulgaria’s external vulnerabilities. Bulgaria has achieved much since the 1996-97 financial collapse: a currency board linked to the euro has anchored stability-oriented fiscal and incomes policies; a largely foreign-owned modern banking sector has developed from scratch; and EU accession has triggered a sweeping upgrade of Bulgaria as an investment location. With Bulgaria’s economic policies broadly in line with Fund advice (Box 1), the reward has been robust, albeit not spectacular, catch-up growth. Accelerating sustainable real income convergence has to remain Bulgaria’s overriding longer-term policy priority. However, massive and unexpectedly protracted capital inflows have resulted in a soaring current-account deficit, raising more immediate concerns about internal and external stability prospects, concerns accentuated by a recent raft of reports and speeches belaboring the external vulnerabilities of high current-account deficit countries in emerging Europe in general and Bulgaria in particular.

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Bulgaria’s overriding objective has to be real income convergence...

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Source: Eurostat.
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... but soaring capital inflows and external deficits are raising stability concerns.

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Source: WEO.

Bulgaria’s Reactions to IMF Advice

Since the establishment of the currency board in 1997, Bulgaria has had an excellent working relationship with the IMF. Policies have generally been consistent with IMF recommendations, as reflected in the successful completion of a series of Stand-By Arrangements. In particular, fiscal and incomes policies in recent years have responded prudently to the widening external deficit. However, structural reforms that require strong domestic consensus have tended to linger on the political backburner.

2. The Article IV discussions focused on key policy requirements to contain and manage Bulgaria’s external vulnerabilities and achieve deeper integration with the EU. Notwithstanding Bulgaria’s often fractious and volatile politics, all main political forces strongly and unequivocally support maintaining the currency board in the transition to euro adoption, and policy requirements were discussed with this perspective in mind.

II. Background

3. Bulgaria’s already large external imbalance has continued to widen, and underlying price pressures have picked up, although the economy’s internal imbalance remains contained. Massive capital inflows, particularly foreign direct investment (FDI) flows, are at the root of an unexpectedly persistent absorption (domestic demand) boom. The widening gap between the economy’s absorption and GDP is reflected in a ballooning current-account deficit, projected to reach about 20 percent of GDP in 2007 (Figure 1, Tables 1-3).1 Net capital inflows in 2007 could top 30 percent of GDP, far in excess of what is needed to finance the external deficit. In fact, about one third of net capital inflows during 2004-07 added to international reserves (Table 4). Turning to the economy’s internal balance, real GDP growth has remained steady at just over 6 percent, reflected in a still moderate output gap estimate. But with labor market conditions tightening, underlying wage and price pressures have gradually picked up. In recent months, headline inflation, as measured by the Harmonized Index of Consumer Prices (HICP), surged into double digits, mainly owing to food- and energy-price shocks.

Figure 1.
Figure 1.

Bulgaria: Key Macroeconomic Forces at Work, 2002–07

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Sources: WEO; Eurostat; and Fund staff estimates and projections.
Table 1.

Bulgaria: Selected Economic and Social Indicators, 2004–08

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Sources: Bulgarian authorities; Fund staff estimates and projections; and World Development Indicators database.
Table 2.

Bulgaria: Real GDP by Expenditure Category and Implicit Deflators, 2004–08

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Sources: National Statistical Institute (NSI); staff estimates and projections.

Private and public sector components based on staff calculations and not officially reported by the NSI.

Including inventories.

Contributions to GDP growth.

Table 3.

Bulgaria: Balance of Payments, 2005–2012

(In millions of euros, unless otherwise indicated)

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Sources: Bulgarian authorities; and Fund staff estimates and projections.
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Bulgaria: Internal and External Balance, 2002-07

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Source: Fund staff estimates.1/ Actual current-account deficit minus estimated equilibrium current-account deficit (see Box 2).2/ Percent deviation of actual from potential GDP (output gap).

4. Bulgaria’s absorption boom reflects largely a private investment boom. The changes in savings-investment balances during 2004-06 indicate that the foreign-savings influx has financed a boom in private investment. The private investment-GDP ratio surged well above its historical average, while the private consumption-GDP ratio remained close to average (Figure 1). Thus, private consumption has not been a driver of Bulgaria’s absorption boom, a conclusion also consistent with an only moderate pickup in imported consumer goods. Moreover, growing fiscal surpluses have accompanied the private sector’s widening financial deficits, indicating that fiscal policy was also not an absorption-boom driver (Table 5). While Bulgaria’s absorption boom shares similarities with recent trends in the Baltic countries and Romania, Bulgaria’s relatively favorable combination of large FDI inflows, low exposures of banks to mortgages, and prudent fiscal and incomes policies stands out (Figure 2).

Table 4.

Bulgaria: External Financial Assets and Liabilities, 2005–12

(In millions of euro, unless otherwise indicated)

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Sources: BNB; NSI; and Fund staff estimates and projections.
Table 5a.

Bulgaria: General Government Operations and Balance Sheet, 2004–08

(In millions of leva)

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Sources: Ministry of Finance; Eurostat; and Fund staff projections.
Table 5b.

Bulgaria: General Government Operations and Balance Sheet, 2004–08

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Actual fiscal balance adjusted for the automatic effects of both internal imbalance (output gap) and external imbalance (absorption gap) on fiscal position; see Selected Issues Chapter III.

Percentage deviation of actual from potential GDP.

Percentage deviation between actual absorption and the level of absorption consistent with external balance.

Figure 2.
Figure 2.

Bulgaria and Selected New Member States: Similarities and Differences in their Absorption Booms, 2004–06

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Sources: National authorities; IFS; EMED; Haver; and Fund staff estimates.

Bulgaria: Savings-Investment Balances, 2004–06

In percent of GDP

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Sources: Bulgarian authorities; and staff estimates.

5. Bulgaria’s private investment boom likely reflects a one-off re-assessment of the country as an investment location.2 The currency board has locked in relatively low risk-free real interest rates, but these low rates can not fully explain the observed investment boom. Prices of financial and real assets—including sovereign bonds, equity, real estate—have skyrocketed only in recent years, roughly in tandem with a sharp drop in Bulgaria’s country-risk scores (Figure 3). With an open capital account and international capital in search of yield as backdrops, risk premia on Bulgarian investment projects seem to have declined mainly for two reasons: (i) investors’ previous concerns about elevated macroeconomic risks were largely addressed by the sustained and successful operation of the currency board; and (ii), investors’ earlier concerns about microeconomic risks, particularly the security of property rights in the nontradables sectors, largely faded once EU accession was secured. In fact, recent FDI has been mainly absorbed by the nontradables sectors, raising concerns about Bulgaria’s export prospects. However, globalization has rendered the conventional distinction between tradables and nontradables sectors increasingly blurry. Moreover, the share of real investment—as opposed to FDI—in Bulgaria’s tradables sectors has remained broadly unchanged.

Figure 3.
Figure 3.

Bulgaria: Asset Price and Country Risk Developments, 2001–07

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Sources: Bloomberg; Bulgarian authorities; Economist Intelligency Unit; Czech National Bank; Moody’s; Statistics Estonia; and Latvia Real Estate Broker.
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The tradables sectors’ investment share has held up well during the investment boom.1/

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Sources: NSI, and Fund staff calculations.1/ Tradables sectors include agriculture, fishing, mining, and manufacturing.2/ July 2006-June 2007.

6. The widening current-account deficit has not been accompanied by a significant loss of external competitiveness. The present external deficit clearly exceeds sustainable levels: staff estimates of Bulgaria’s equilibrium current-account deficit are centered around 8 percent of GDP, subject, however, to considerable margins of uncertainty (Box 2). At the same time, real effective exchange appreciation over recent years has been moderate when benchmarked against conventional relationships between the exchange rate and the current account. Purchasing-power-parity and dollar-wage comparisons across countries, as well as recent trends in export market shares, also suggest that Bulgaria’s prices and costs remain broadly competitive. Finally, regression-based estimates of the real equilibrium exchange rate also do not indicate signs of substantial overvaluation (Box 2).

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Bulgaria’s ballooning current-account deficit has been accompanied by limited real appreciation.

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Source: Fund staff estimates.1/ Based on standard elasticities for exports (-0.71) and imports (0.92) with respect to real exchange rate changes.

7. But Bulgaria’s net IIP is deteriorating fast. External financial liabilities have continued their steep upward climb in 2007, and the net IIP could deteriorate to about 65 percent of GDP (Table 4). However, external liabilities represent mostly FDI and long-term debt, with short-term debt more than fully covered by international reserves. Nevertheless, the widening currency mismatch position of nonfinancial corporates (excluding intercompany loans) is a concern, as it reflects rapidly growing and at least partly unhedged corporate borrowing abroad.

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Bulgaria: Sectoral Currency Mismatches

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Sources: BNB; Fund staff estimates.1/ Excluding intercompany loans.

Bulgaria: Inputs for External Stability Risk Assessment 1/

Staff estimates of the equilibrium current-account deficit center around 8 percent of GDP:

  • The macroeconomic balance approach, based on panel data for 38 industrial and transition countries for 1992-2006, suggests that Bulgaria’s current-account deficit norm is somewhat above 5 percent of GDP. However, this estimate is backward-looking and might underestimate the sustainable current-account deficit in a setting of globalized financial markets and EU convergence.

  • External sustainability considerations based on stabilizing the net international investment position (IIP) at a medium-term level of about 80 percent of GDP, but ignoring EU capital grants, point to a sustainable current-account deficit of about 8 percent of GDP.

  • Bulgaria is likely to receive EU capital grants amounting to about 2 percent of GDP, and the sustainable current-account deficit could be correspondingly higher as these grants will not add to Bulgaria’s external liabilities.

Notwithstanding the presently large current-account deficit relative to equilibrium, the real effective exchange rate appears fairly valued (Box Figure):

  • Different measures of Bulgaria’s real effective exchange rate have all appreciated over recent years, but the pace of appreciation has been in line with experiences in other transition economies.

  • Purchasing-power-parity and dollar wage-cost comparisons in industry across countries also yield no strong evidence of overvaluation.

  • Estimates of the real equilibrium exchange rate (CPI based) as a function of relative productivity and the net foreign asset position during 1996-2006 indicate that the actual real exchange rate has appreciated largely in line with the estimated equilibrium real exchange rate.

  • Recent export volume growth (11 percent during 2004-06) remained solid, and export market shares have increased in all major export destinations. However, a constant market share analysis at SITC 1-digit product level indicates some erosion of competitiveness relative to other low- and middle-income countries during 2004-05, albeit coming on the back of large gains during 2001–03.

1/ See Selected Issues Chapter II “An Assessment of Bulgaria’s External Stability Risks.”
Box 2 Figure.
Box 2 Figure.

Bulgaria: Real Exchange Rate Developments

Citation: IMF Staff Country Reports 2007, 389; 10.5089/9781451804577.002.A001

Sources: ILO; IFS; Eurostat; and Fund staff estimates.

8. Domestic bank credit has started to boom again, but the banking sector maintains significant buffers against a credit-cycle downturn. Since administrative limits on bank credit lapsed at end-2006, credit growth has accelerated to over 50 percent (Tables 6-7). In response, in September 2007 the BNB raised reserve requirements from 8 to 12 percent, noting that it would be ready to adopt additional measures to moderate credit growth if needed. Financial soundness indicators continue to suggest that the largely foreign-owned banking sector remains well capitalized and profitable (Figure 4, Table 8). Nonperforming loan ratios remain low, though this partly reflects rapid loan portfolio growth. Moreover, banks’ exposures to the booming real estate market are still limited, as purchases by nonresidents have been the key market driver.

Table 6.

Bulgaria: Monetary Accounts, 2005–12

(In millions of leva, unless otherwise stated)

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Sources: Bulgarian National Bank, National Statistics Institute, and Fund staff estimates.