The end of the capital-inflows driven domestic demand boom

Until late 2008, Bulgaria experienced high growth rates and a rapid catch-up with the EU countries. The confidence inspired by a good economic performance and, more recently, by the accession to the EU has continued to attract substantial amounts of private capital inflows, mostly in the form of FDI. While the surge in inflows did generate strong GDP growth (above 6 percent on average for the last four years), it also caused a sharp widening of the external current account deficit as the increase in domestic demand outpaced GDP growth.

As a consequence of the global financial crisis that followed the default of Lehman Brothers, the investment-driven boom came to an end. Capital inflows, that were fueling growth for years, dried up which led to a significant contraction of domestic demand. On top of that, the recession that hit Bulgaria’s main trading partners, mostly EU countries, caused a substantial drop in exports. The impact of these two shocks was fully felt in the second half of 2009 when it became obvious that the economy will record the first contraction in more than a decade. The decline in domestic demand and the reduction of imports, in turn, led to a swift correction of previously built-up internal and external imbalances as evidenced by the sharp decline of inflation and current account deficit. At the same time, the decline in domestic demand, consumption in particular, along with shrinking imports, caused a considerable drop in fiscal revenues which eventually resulted in an overall budget deficit–the first one since 2002. The level of public debt, however, remained low (about 16 percent of GDP) and is not projected to rise.

The financial system, dominated by the banking sector, remained stable. Following the global financial turmoil that started in 2007 and intensified after September 2008, foreign funding declined, resulting in strong competition for deposits and a sharp reduction in credit growth. The interbank market was affected as well but calmed down after some targeted steps taken by the central bank it. Subsequently, volumes have resumed and interest rates have moderated.

The policy response

The effects of the global financial crisis were exacerbated, to some extent, by the political cycle and the large spending increases in the run up to the July 2009 parliamentary elections. However, the new government that took office after the elections promptly reversed the trend by implementing across-the-board spending cuts, in particular for maintenance and capital spending. Thus, the government managed to contain the cash deficit to just 0.9 percent of GDP. On accrual basis, however, the deficit is higher, currently estimated at about 3.9 percent of GDP. This rather big upward revision reflects accumulation of arrears due to some previously unidentified payment commitments for capital, maintenance and healthcare spending as well as exclusion of revenue of some cash dividends that were received in 2009. It should be clarified, though, that a large part of the accumulated arrears is due to ongoing revisions of the annexes to the contracts that various ministries had signed before the elections. The government is well aware that repayment of the arrears should be swiftly pursued to prevent cascading of arrears in the private sector. It has already started to repay to those firms where the revisions have been finalized.

With regard to the 2010 budget, the authorities are trying to preserve fiscal sustainability in the context of possible further slumps in revenue. In this regard, the National Revenue and Customs Agencies have been restructured to allow for more and better coordinated inspections so as to improve tax compliance. The excises on cigarettes, as well as taxes on real estate were raised. On the expenditure side, cuts are planned in a number of areas. Wages and general pensions in 2010 will be frozen and no end-year bonuses will be paid. The number of civil servants will be reduced by 3 percent and the originally planned increase of pensions to widowers and those over 75 years old was delayed. Moreover, while capital spending and subsidies are budgeted to rise, the increase is contingent on the expected higher absorption of EU funds and could be halted if absorption falls short of targets.

The authorities realize that fiscal policy will be challenging in the near future. As the crisis deepened, the overall fiscal deficit of 0.7 percent of GDP budgeted for 2010 is hardly achievable. Accordingly, the government is working on a new budgetary framework and a new set of measures. On the revenue side, measures include the sales of emissions under the Kyoto protocol, introduction/increase in lottery, gambling, and luxury taxes, as well as the rent and sale of state-owned land. All this is estimated to yield about 2.4 percent of GDP which, along with additional across-the-board cuts in current spending, will help offset revenue shortfalls (mostly VAT) and higher payment obligations. These measures notwithstanding, the overall fiscal deficit for 2010 (on cash basis) is now estimated to reach about 2.5 percent of GDP and about 2 percent on accrual basis. This said, the authorities stand ready to take further measures (including by raising the VAT rate) to preserve fiscal sustainability. By applying such an approach the authorities reaffirm their strong commitment to sound macroeconomic policies, acknowledging the paramount importance of a prudent fiscal stance.

With regard to the financial sector, thanks to the prudent regulation in the years before the crisis, the banking system has built up substantial buffers. The existing capital buffers, in particular, together with further countercyclical macro-prudential measures should allow the banking system to absorb the increase in NPLs and associated provisions. The BNB has asked banks, as it did in the previous year, to fully retain earnings which will add to capital buffers. Furthermore, the BNB recently implemented additional countercyclical measures such as the alignment of its risk-weights on the EU standards, which are less conservative, and inclusion of current and previous year earnings in the calculation of own funds. In addition, and in relation to recent economic developments in some neighboring countries, the central bank has intensified the liquidity monitoring and initiated regular exchanges of information with parent bank supervisors.

The challenges ahead

The authorities are fully cognizant that the end of the capital-inflow driven boom creates significant policy challenges. Recent economic developments in Bulgaria, as well as in the region as a whole, suggest the need of a swift change in policy priorities. Until just a short time ago, these were speeding up convergence and raising living standards, whereas now the priority is focused primarily on preserving macroeconomic stability. In this regard, the most important challenge is ensuring that the drop in capital inflows does not result in a confidence crisis. Accordingly, the authorities attach great value to maintaining confidence in the currency board arrangement and the financial system. Keeping public finances in check is regarded as the key instrument.

Given the paramount importance of fiscal policy in the context of the currency board arrangement, the authorities agreed with staff that an important policy challenge will be to shift from ad hoc fiscal measures to a medium-term strategy of fiscal policy from 2011 and beyond. More specifically, it was agreed that giving fiscal policy a larger role in stabilizing the economy can be achieved by focusing, within a medium-term budgetary framework, on the overall spending envelope rather than on headline balances. Under such a framework, targeting real spending growth in line with cautious estimates of potential GDP growth would make public spending more predictable, and help prioritize spending while avoiding across-the-board-cuts. In addition, any revenue windfalls could be used to build up fiscal buffers that can be drawn down in times when revenues fall short.

As the crisis escalated last year, there were some concerns that it might trigger a balance of payments or banking crisis which would have forced the country to seek financial assistance. Those concerns did not materialize. What happened was that the downturn led to a correction of previously built-up flow imbalances. While capital inflows will, over time, recover from the low levels during the crisis, an important policy challenge for the economy is to provide a business-friendly environment.

Finally, with regard to the ERM II, the authorities maintain their long-stated position that they will seek joining at the earliest possible date. The ongoing global financial crisis may delay somewhat the process but has not changed the authorities’ determination. On the contrary, they have started talks with their European partners and are ready to provide them with firm and detailed policy commitments. The authorities’ plan is to uphold the currency board arrangement at the existing exchange rate until Bulgaria joins the euro area. The Bulgarian government and the central bank have committed to unilaterally maintaining a zero deviation of the exchange rate after Bulgaria joins the ERM II.