BULGARIA: ECONOMIC CLOUDS ON THE HORIZON, BUT TOO

UNCLAS SECTION 01 OF 03 SOFIA 002120

SIPDIS

USDOC FOR 4232/ITA/MAC/EUR/OEERIS/SAVICH

E.O. 12958: N/A
TAGS: EFIN ECON EINV BU
SUBJECT: BULGARIA: ECONOMIC CLOUDS ON THE HORIZON, BUT TOO
EARLY TO PREDICT A STORM



1. (U) SUMMARY: Having already risen above the 2005
forecast of 3.5 percent, Bulgaria's inflation rate is
expected to jump dramatically to 8.4 percent in the first
quarter of 2006 thanks to higher fuel prices and an increase
in excise taxes to match EU minimum levels. However,
inflation is expected to fall in the second half of 2006 and
further decline in 2007. Apart from inflation, the GOB in
2006 will have to contend with the economy's two other major
problems--the soaring current account deficit of 14 percent
of GDP for 2005, and increasing external debt of 63 percent
of GDP. The government's tight fiscal policy and central
bank's restrictions on bank lending are cooling growth in
domestic demand, resulting in an estimated overall GDP
growth of about 5.5 percent for 2005. Despite the stalled
privatization process, investment activity has remained
strong. Foreign direct investment (FDI) is estimated to top
two billion euro in 2005, spurred by a higher number of
green-field investment projects. With average monthly wages
still at about USD 200, the government is under pressure to
raise wages, but must balance calls for a wage hike with the
need to maintain tight fiscal policy and keep inflation
under control. END SUMMARY.

UPWARD PRICE MOMENTUM
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2. (U) Bulgaria's inflation rate is likely to exceed the
official forecast of 3.5 percent for 2005 and is predicted
to spike in the beginning of 2006. Between January and
November 2005, the consumer price index posted a 5.6 percent
increase. The rise in prices was caused by higher prices
for food (as a result of the recent floods),electricity,
heating, and fuel (due to global oil prices rise). Price
pressures have led the central bank to forecast a worrying
inflation rate of 8.2-8.4 percent in the first three months
of 2006 on a year-on-year basis. The higher price level in
2006 will be primarily driven by higher excise taxes. The
Bulgarian parliament recently approved amendments to the
excise tax law confirming the government's plan to introduce
the EU minimum excise tax levels before the country joins
the EU. As a result, the prices of cigarettes, spirits and
automobile fuel will increase by 65 percent, 17 percent and
4.6 percent, respectively.


3. (U) Despite an initial jump in inflation, the government
is forecasting an overall inflation rate of 4.9 percent for

2006. Independent observers believe, however, that the
government's move to initiate the excise tax increases will
keep inflation above 5 percent over the next year. After a
rise in early 2006, inflation is expected to decline
considerably into 2007, as the price shocks linked to
meeting the EU minimum levels of excise taxes will not be
repeated and anticipated falling oil prices will also reduce
external inflationary pressures.


4. (U) Despite the price push, the central bank has welcomed
the government's plan to conform to the EU levels of excise
taxes. The central bank believes the inflation target will
be the most difficult EU convergence criteria to fulfill
because of the lack of independent monetary policy and
control over inflation, the result of a currency board
arrangement.

CURRENT ACCOUNT AND EXTERNAL DEBT REMAIN MAIN CONCERN
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5. (U) High oil prices and strong domestic demand have
contributed to a sharp increase in Bulgaria's current
account deficit during the first ten months of 2005 -- to
2.2 billion euro or 10.5 percent of GDP, as compared to 918
million euro or 4.7 percent of GDP last year. As a result,
the deficit for the year as a whole is expected to be about
14 percent or 2.9 billion euro. Finance Minister Oresharski
has said the chronically high current account deficit is the
government's biggest concern and the GOB will seek to limit
the deficit to 12 percent by the end of 2006. According to
the press, the government may have to resort to some drastic
measures--such as freezing wages and increasing the VAT--if
the problem persists.


6. (U) Bulgaria's gross external debt has been increasing
throughout the year due to an increase in private foreign
debt. In October 2005, gross foreign debt stood at 13.4
billion euro or 63 percent of GDP, up by seven percent or
888 million euro relative to December 2004. In contrast,
the government's well-managed debt policy has lead to a
substantial decrease in the stock of government debt.
Thanks to the two Brady Bond buy-back deals, foreign
government debt stood in October 2005 at 6.9 billion euro or
32 percent of GDP. Next year the government foreign debt is
expected to decline further as the Finance Ministry carries
out its plan to retire part of IMF/WB debt in January 2006.

GDP GROWTH LOSES STEAM IN THIRD QUARTER
--------------


7. (U) Following a record-high GDP growth of 6.4 percent in
the second quarter of 2005, Bulgaria's GDP growth slowed to
4.6 percent in the third quarter of 2005. The primary cause
of the slowdown was a sharp decline in agriculture
production, a result of the devastating floods in the summer
and early fall of this year. Agriculture production in the
third quarter dropped 6.6 percent relative to the same
period last year. This decline was offset by growing
industrial production (up 6.5 percent) and services (up 4.8
percent). With a GDP growth of 5.6 percent from January to
September 2005, the central bank continues to estimate total
GDP growth for 2005 at 5.4-5.8 percent. While the
government economic program calls for a slightly lower real
GDP growth of 5.5 percent, other independent observers
believe GDP growth will reach 5.7 percent.

SHIFTING FOCUS TO GREENFIELD INVESTMENT
--------------

8. (U) New foreign direct investment (FDI) in the period of
January through October 2005 increased by only five
percent--to 1.466 billion euro--compared to the same period
last year. The decline is due to a halt in the
privatization process. To date this year, there has been no
foreign investment linked to privatization, as compared to
325 million euro spurred by privatizations for the same
period in 2004. The Bulgaria Investment Agency (BIA)
estimates FDI of more than two billion euro for 2005 thanks
to the expansion of existing foreign investment as well as
the green-field investment projects to be completed by the
end of the year. The largest sources of this new FDI are
Austria, with 31.5 percent, followed by U.K. and
Switzerland. FDI covered 66 percent of the current account
deficit.

UNEMPLOYMENT HISTORICALLY LOW
--------------


9. (U) The latest labor market data continue to demonstrate
the trend of falling unemployment. According to the
Ministry of Labor and Social Policy, unemployment hit a ten-
year low of 10.4 percent (383,930 unemployed) in November

2005. The positive employment trend is largely attributable
to the larger number of people who started work under
government sponsored employment programs. Despite the
encouragingly low level of unemployment, the regional
breakdown shows that the unemployment rate continues to vary
widely throughout the country. While in major cities the
unemployment remains low as compared to the national level
(2.9 percent in Sofia for example),there are other regions
with double-digit unemployment: Turgovishte-22.9 percent;
Montana-20.9 percent; Vidin-19.5 percent; Razgrad-17.8
percent; and Shoumen-17.4 percent.

BUDGETARY SURPLUS; DECLINE IN CREDIT GROWTH
--------------

10. (U) The Bulgarian government's measures to curb buoyant
domestic demand include a tight fiscal policy and credit
growth restrictions. The government originally planned a
budget deficit of 0.5 percent of GDP in 2005, but agreed
with the IMF to target a surplus of one percent of GDP in
order to prevent domestic demand from overheating. The
Finance Ministry estimates that the 2005 consolidated budget
will run a surplus of two percent of GDP (about 500 million
euro). In October 2005, the consolidated budget registered
a surplus of one billion euro.


11. (U) The measures the central bank took earlier this year
have been successful in moderating credit growth. The
growth rate in non-government sector credit slowed to 32.5
percent in the period between January-November 2005, and is
most likely to reach the targeted rate of 30 percent by the
end of the year. The additional measures introduced by the
central bank in November 2005 will lead to a further drop in
credit growth, with a target of 16 to 20 percent for 2006,
according to the central bank. However, non-bank financial
institutions - called "leasing companies" in Bulgaria - have
to some extent offset the central bank's efforts to restrict
credit.

COMMENT
--------------


12. (SBU) While the GOB's efforts to stem bank credit growth
have been effective, the IMF is still expected to continue
to pressure Bulgaria to maintain tighter fiscal policy and a
budget surplus of three percent to counter its growing
current account deficit. We will continue to pay close
attention to the GOB's ongoing negotiations with the IMF,
especially after parliament in December passed a balanced
2006 budget despite IMF insistence on a surplus. Although
the government is resisting certain pressures from the IMF,
the center-left ruling coalition, led by the Bulgarian
Socialist Party (BSP),has demonstrated its resolve to
preserve macroeconomic stability and keeping the economy
growing. The GOB's chief economic policy priorities now are
to maintain fiscal discipline, attract higher inflows of
foreign green-field investments and prepare the country to
meet EU convergence criteria. The government, however,
needs to re-energize the privatization process and work with
the IMF to institute the right mix of economic policies to
adequately address Bulgaria's looming current account
deficit and growing external debt. End Comment.

LEVINE