Bulgaria: Economic Performance, Prospects and Risks Craig Otter, Economist Intelligence Unit May 11 th 2007

Outline  Economic performance  Economic prospects  Key challenges  Conclusion

Growth robust and stable Real GDP growth, % and contributions, pp

Falling unemployment Unemployed persons, % of labour force

Moderating price and wage inflation Consumer price index and wages, average % change

Supportive fiscal policy Government budget balance, % GDP

Credit expanding fast, but level low Growth in domestic credit stock

External weakness growing External balances, % of GDP

Overall debt dynamics favourable External debt, % GDP

Foreign capital inflows booming Foreign Direct Investment, US$mn

FDI shifting focus FDI by sector, average share of total FDI in

FDI shifting focus (continued) FDI by sector, average share of total FDI in

Capital investment driving potential output Growth in labour, capital and total factor productivity, %

Business environment improves World Bank Ease of Doing Business Rank (1 = highest)

Catch-up proceeding slowly Ratio of Bulgarian to EU-27 and CEE GDP per head at PPP

Catch up: GDP per head, EU15=100 EU15 growth at 2% pa

Currency board  Reserves have been rebuilt since  Authorities were unable to prevent financial crisis in and decline in external value of the lev  Peg has been in place since July 1997  Currency pegged to D-Mark and currency restrictions introduced  Anchor currency shifted to euro in 1999, restrictions lifted in 2000  Base money is matched by foreign reserves  Elements of currency board  A fixed exchange rate between lev and euro (BGN1.96=EUR1.00)  Convertibility of lev  A long-term commitment to the system by the authorities  Threats to currency board contained for now  Disinflation and euro weakness have mitigated real appreciation pressures under currency board system since 1997  However, rising price pressures and weaker US dollar against euro in have suggest real appreciation could place currency board under strain

Currency board Reserves and the monetary base (US$ m) M1 includes demand accounts

Economic prospects  Strong GDP growth  Inflation resumes downward momentum  Fiscal policy remains tight  Monetary policy dedicated to currency board  Even if lev appreciation, cost-advantage remains  Large current-account deficits  Manageable external debt service  Strong, though falling, FDI inflows  High levels of reserves  Continuation of reforms

Real GDP growth, % Growth to remain rapid

Inflation, average annual % Disinflation to continue

Current account balance, % GDP External weakness to persist

Net FDI inflows, US$bn FDI receipts to start falling

Net FDI inflows, as % of GDP FDI receipts to start falling (continued)

Economic risks  Managing underlying vulnerabilities  External deficit  Continuing structural reform post-EU  Maintaining reform momentum after EU accession  A very poor demographic outlook  Need to review labour market incentives  Growth challenge can +5% pa growth be sustained?

Net FDI inflows, % of Current account balance CA deficit financing has deteriorated

External deficit  Has grown partly as a consequence of FDI inflows  This has been shown to a be key factor in supporting income convergence …  but economic vulnerability is higher nonetheless  Private sector foreign borrowing is more worrying  Need to monitor risks allied to foreign borrowing  Export performance crucial  Although non-trade elements of CA have also deteriorated, hopes for improving external stability rest with a recovery of exports  Data certainly no clear price- or wage-based competitiveness concerns  But continuing structural reforms needed to ensure state enterprises are restructured  Sustainability threat not obvious  IMF research suggests that CA imbalance is broadly consistent with Bulgaria’s stage of economic development

Price competitiveness Gross monthly wages, US$ Predicted ActualAct/prPredictedActualAct/pr Czech Bulgaria Hungary Romania Poland Albania Slovakia B & H Slovenia1,3981, Croatia Estonia Macedonia Latvia Serbia Lithuania “Equilibrium wages” estimated or predicted on the basis of a relationship between wages and productivity (output per employed, at PPP) and several other variables, across 70 economies.

EU membership and growth Positive  Reinforces political stability, reduces risks  Impact on trade/FDI; removal of residual trade barriers  Institutional development aided, albeit over long time frame  Encourages macro policy discipline  EU funding for infrastructure development Negatives  Membership removes reform anchor  Much of acquis inappropriate for less developed  Harmonisation pitfalls - EU social and environment regulation - Pressure for tax harmonisation  Stability or growth bias

EU entry offers a possibility, not a guarantee of stimulating per-capita GDP convergence Key assumptions: trade integration; macro stability and price competitiveness; further deregulation; slow institutional improvement Modest pace of convergence. On baseline forecast, by 2025 Bulgaria reaches about 40% of EU-15 average income per head, from less than 30% at present Despite post-accession benchmarking, risk that Bulgaria’s commitment to EU-related reform weakens in line with greater political disunity EU membership and growth

A declining and ageing population Population by age group, thousands and dependency ratio

Bulgaria’s population has been declining for more than a decade It is projected to decline by another 24% by 2035 and the working-age population by 31% Policies needed to encourage higher labour market participation Incentives need to be reviewed to ensure that participation in the labour force is more effectively encouraged The IMF has called for a “release of excess staff from the public sector”, which it believes would lead to higher labour supply to the private sector Poor demographics shared by most CEE states, a produce of net migration and negative natural population increase Adverse demographics

Assessment of currency board risks  External deficit  Much of the external deficit is consistent with Bulgaria’s stage of economic catch-up  Non-debt creating finance (FDI) has helped to finance current account deficit, but financing is expect to deteriorate  Public finances  Very restrictive (budget balance in surplus since 2004, primary balance in surplus since 1994).  Fiscal overperformance has been used to build up a huge fiscal reserve, and has used this to make early repayments of public sector external debt.  Private sector debt accumulation  Perhaps most worrying aspect of recent economic developments  rivate sector component has been rising rapidly, while public sector component has been coming down because of the government's aggressive prepayments.  Private sector credit growth a concern  Debt structure  75% of Bulgaria's external debt in euros. No large market of BGN-denominated instruments to serve as a channel for forcing currency adjustment. Portfolio inflows (hot money flows) are relatively minor.  Banking sector  Overwhelmingly under foreign control and improving in terms of profitability and stability.

Summary of challenges Nature of challenge Growth Keep well-balanced Inflation Emerging energy dependence could increase inflation Fiscal policy Maintain tight fiscal policy Monetary policy Preserve currency board despite large external deficit, manage credit growth and banking sector risk External sector Manage and reduce vulnerability FDI Ensure opportunities for greenfield investment when privatisation program comes to an end Competitiveness Address problem of falling working-age population, invest in R&D to decrease reliance on labour-cost advantages Business environment Need to further improve institutions and regulations