BULGARIA'S CURRENT-ACCOUNT DEFICIT WORSE THAN EXPECTED, BUT

UNCLAS SOFIA 000360 SIPDIS DEPT FOR EUR/NCE MNORDBERG SENSITIVE SIPDIS E.O. 12958: N/A TAGS: EFIN ECON PGOV EINV BU SUBJECT: BULGARIA'S CURRENT-ACCOUNT DEFICIT WORSE THAN EXPECTED, BUT NO CAUSE FOR ALARM YET ¶1. (SBU) SUMMARY: Bulgaria's Current Account (CA) deficit exceeded even the gloomiest expectations, coming in at 16 percent of GDP growth in 2006. The deficit was fuelled mainly by the growth of the foreign trade gap which increased to a record 21.8 percent of GDP last year. Strong export growth performance and foreign direct investment (FDI) inflows were the few bright spots in the picture. Both the GOB and independent analysts assert the CA deficit is not a problem as it has grown on the back of strong investment activity. The GOB is committed to continue fiscal discipline and to new structural policies that curb further expansion of the CA deficit. END SUMMARY ¶2. (U) Bulgaria's CA deficit reached a record 16 percent of GDP growth in 2006 (USD 4.9 Billion),preliminary central bank figures showed. The new deficit is well above the previous two years - 11.3 percent or USD 3.0 Billion in 2005, 5.8 percent of GDP or USD 1.4 Billion in 2004 - and much worse than the most pessimistic projections of 15 percent for 2006. The deficit was exceptionally strong in December - increasing 85 percent year-on-year - on strong consumer goods imports in advance of the hike in some excise taxes on January 1, 2007. Through the year, the CA deficit continued to be fuelled mainly by the growth of the foreign trade gap which increased to a record 21.8 percent of GDP in 2006 (against 20.2 percent in 2005). Rampant domestic consumption due to a booming economy has supported high import growth over the past few years, while domestic export capacity is still inadequate reflecting domestic industry's resistance to restructuring. BRIGHT SPOTS BEHIND THE CLOUDS ¶3. (U) A strong export growth rate of 26.6 percent year-on-year was a positive sign last year and outpaced for the first time in many years the growth of imports at 25.3 percent. Robust FDI inflow supported a favorable financial account, while foreign exchange reserves covered over 5 months of last year's imports. FDI, which reached USD 4.9 Billion or 16.6 percent of GDP in 2006, was mainly in real estate, construction, and communication - not strong export-growth sectors. ¶4. (SBU) Neither the government, nor the independent analysts we spoke to are worried about the rising CA deficit as long as it remains largely or fully covered by FDI - 104 percent in 2006. Both sides contend that the rising FDI is causing a subsequent increase in the import of investment goods, which is good for long-term economic development but worsens the foreign trade and CA balance. At the same time, a large portion of the imported raw materials and energy resources - 50 percent and 35 percent, respectively - are used in export-oriented production. GOB GETS TOUGH ON CA DEFICIT ¶5. (U) For the first time this year, the GOB included future CA deficits as a yardstick to control fiscal spending. The GOB will not spend the last 10 percent of its budget if the expected 2007 CA deficit as of end-September 2007 is higher than last year's 16 percent of GDP. The GOB's tight fiscal stance also entails cautious public spending on imported goods - consumer and investment mainly - to avoid further opening of the CA gap. The central bank's vigilant policies on domestic credit growth should ensure the growth of private consumption remains under control, too. On the supply side, the GOB is relying on EU aid to modernize industry and its export capacity, while a law on small and medium enterprises supports measures to encourage export-led production. IMF CAUTIOUS ¶6. (U) The IMF estimates that the CA deficit in 2007 will remain as high as last year's - around 15.8 percent. The Fund argues that certain favorable industry performance - such as the steel industry - may have an upbeat effect on overall exports in 2007. The Fund has been a steady beacon warning the GOB against lavish budget spending and further widening of the CA deficit, and will continue this message even after it exits at the end of March. ¶7. (SBU) COMMENT: The CA deficit is very high, but government and banking officials claim that because of high FDI levels, and security of the banking system, Bulgaria is not in danger. If the CA deficit is to widen further - or FDI to fall - it could jeopardize the currency board arrangement and the government's mid-term economic plans. While Bulgaria's exports will likely continue to rise, export volume will largely depend on how quickly the domestic economy is able to compete following EU membership. The government should stick to its tight fiscal policies - yielding a fourth consecutive budget surplus - and put in more structural reform measures to maintain the strong economic climate while significantly re-building business-related infrastructure. BEYRLE