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Monitoring: Crash course for Bulgaria?

Bulgaria entered the EU a year ago to great fanfare, but its ever increasing inflation and current-account deficit numbers suggest the party may now be over.

Bulgarian annual price rises have jumped from the single-digits in 2006 to 12.6% year-on-year in November 2007. Meanwhile, the current-account deficit came in at a whopping 17% of GDP for the year to October and will likely top 20% of GDP for 2007 as a whole. Not long ago a current account deficit of 7% of GDP sent alarm bells ringing. Not surprisingly, analysts have started sounding warnings. A recent WSJ piece pointed to “coming strains” for Bulgaria, saying the country is in an increasingly “tight spot”, as policymakers there are constrained by the currency board (hence, lack of monetary policy tools) from reining in the double-digit inflation and surging imports.

Meanwhile, Danske Bank, in a recent report, classified Bulgaria in the “danger zone”, along with the Baltic states and Romania, saying they are the most likely emerging European countries to face an economic hard landing. On the surface, Bulgaria appears very similar to the overheating Baltics and looks set for a hard landing, but things might not be as dire as they seem. While analysts agree that Bulgaria’s current account deficit is the country’s chief risk and that its trajectory is unsustainable, not all seem as willing as Danske Bank to place Bulgaria in the same “danger zone” as the Baltic states. Some analysts have dissected the capital inflows funding Bulgaria’s current-account deficit, providing insight into the country’s true level of vulnerability. In a recent report, the IMF points out that Bulgaria’s capital inflows are primarily a private investment, rather, than a consumption, story. At the very least, this suggests Bulgaria’s current-account deficit is not the result of a consumer spending binge that would provide no boost to the country’s longer-term productivity.

Between 2002 and 2007, (Bulgaria’s) gross domestic investment as a share of GDP surged by 15 percentage points, mainly due to rising private investment. This sharp increase in investment stands out in the cross-country comparison, not only relative to the neighboring countries but also with fast-growing emerging countries in the other regions. At the same time, the private consumption-GDP ratio has in fact trended downward somewhat—despite the rapid rising retail sales and high household credit growth—while consumer goods imports only picked up moderately.

The IMF concludes Bulgaria’s deficit is largely the result of a one-off private investment boom, triggered by its strong macro stability record and a marked reduction in microeconomic risks (anchored by EU accession). Once the boom tapers off, as the IMF expects will happen, the current account deficit is projected to approach equilibrium levels estimated to be around 8% of GDP, with a range of 5–10% reflecting different estimation methodologies and whether or not future EU capital grants are taken into account. So while the IMF notes that the present trajectory of Bulgaria’s current-account deficit is unsustainable, its assessment does not suggest an abrupt or painful current-account adjustment is imminent or a given. Further solace is provided by the fact that Bulgaria’s current-account deficit does not appear to be the result of eroding external competitiveness, according to both Fitch and the IMF (quoted below).
…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.

To fund its sky-high current-account deficit, Bulgaria relies heavily on continuing capital inflows. That means Bulgaria is vulnerable to any shock or loss of confidence that could stop them. But looking at the structure of Bulgaria’s capital inflows mitigates some of the concern that there will be an abrupt unwinding. Unlike many of its emerging Europe peers, Bulgaria’s FDI in recent years has more than fully financed its current-account deficit. Because FDI is generally longer-term and harder to unwind than portfolio investment, a sudden capital reversal is unlikely, as Fitch notes in a March report. And depending on the destination of the FDI, the current-account deficit could be self-correcting if the FDI boosts Bulgaria’s export capacity, helping it generate revenues to close the trade deficit in the future.

So what sectors is Bulgaria’s FDI flowing into? Are they potential export earners?
A recent EFG Eurobank report finds most FDI is going into manufacturing, which will likely boost Bulgaria’s future export capacity. The problem is a growing proportion of FDI is destined to real estate, a sector unlikely to generate future export earnings that would help close the trade deficit. This is an important trend to keep an eye on in evaluating Bulgaria’s vulnerabilities going forward. At the end of 2006, manufacturing was the sector commanding the highest FDI share (24% of total FDI stock), followed by real estate, renting & business activities (16.3%), financial intermediation (16.1%) and retail trade & repairs (14.3%). Of these sectors, real estate has realized the highest rise in inward direct investment over the past four years (6.9% of total FDI stock at the end of 2002).

How does Bulgaria’s currency board fit into this discussion of the country’s external imbalances? Is the currency board to blame?
This has been alluded to by ECB policymaker Lorenzo Bini Smaghi and by the WSJ when it stated, “Bulgaria is in an increasingly tight spot, with its euro-pegged currency powerless to rein in double-digit inflation and spurring a surge in imports and domestic loans.” It seems unclear that having a flexible exchange rate (and thus having monetary policy as a tool) would significantly reduce Bulgaria’s external imbalances. The argument is that interest rates could be raised to cool the economy. Nevertheless, a change in the exchange rate regime could have the unintended effect of making Bulgaria’s economy less stable and hurting investor confidence in the country, thereby reducing capital inflows.

An added impediment to moving away from the currency board is that it enjoys widespread political support. Many credit the currency board with putting Bulgaria on the right economic track, making the country the attractive FDI magnet it has become. Since the currency board’s introduction in 1997, Bulgaria has enjoyed strong and steady growth, improving living standards, and falling unemployment – a stark contrast from the unstable economic situation prior to its implementation. As a result, support for a switch to a more flexible exchange rate regime is not there. Plus, currency boards traditionally have a better record dealing with inflation so it’s unclear that a switch to a more flexible exchange rate regime would be the answer to getting Bulgaria’s spiking inflation under control, especially since the recent spike is largely due to supply shocks, such as rising world oil prices and drought-induced jumps in food prices.

Fiscal policy is available as a tool to stem domestic demand and the widening current-account deficit, but it’s a blunt tool and there are limits to how much further fiscal tightening can be implemented. As EFG Eurobank points out here, Bulgaria has been running a very responsible fiscal policy. The budget surplus stood at 6.5%-of-GDP of GDP in October, an outcome significantly higher than both a revised full-year target of 3.3% of GDP and the 2% of GDP surplus agreed with the IMF. Some fiscal loosening is expected towards the end of 2007, mainly due to increases in pensions and wages, and we now expect the budget surplus to come in around 3-4%-of-GDP by year end.

Acknowledging Bulgaria’s complicated position as a country with a currency board and widening current-account deficit, IMF Resident Representative James Roaf advocates controls on bank lending as an imperfect solution to cool domestic demand. Like many of its CEE neighbors, the fact that Bulgaria is running a current-account deficit is not surprising since it is trying to “catch-up,” or converge with the EU and needs investment to do so. Yet, Bulgaria’s present current-account deficit trajectory, expected to top 20% of GDP for 2007, is not only unsustainable but also exceptionally high even by emerging Europe standards and leaves the country vulnerable to shocks.

Ideally, Bulgaria’s external imbalances will unwind gracefully and the country’s strong annual GDP growth (above 6%) is expected to continue in 2008, but there are no guarantees. Nevertheless, putting Bulgaria in the same “danger zone” category as the Baltics seems hasty, especially considering the government’s responsible fiscal policy, the fact that the current-account deficit has been financing mostly private investment rather than consumption, and the fact that Bulgaria’s current-account deficit continues to be financed primarily by FDI. (RGE Monitor)