BULGARIA - OVERHEATING ECONOMY OR JUST GETTING WARMED UP?

UNCLAS SECTION 01 OF 03 SOFIA 000828 SIPDIS DEPT FOR EUR/NCE MNORDBERG SENSITIVE SIPDIS E.O. 12958: N/A TAGS: EFIN ECON PGOV EINV BU SUBJECT: BULGARIA - OVERHEATING ECONOMY OR JUST GETTING WARMED UP? ¶1. (U) SUMMARY: Strong domestic consumption in Bulgaria has sparked a large trade deficit and led to a current-account (CA) deficit of 15.8% in 2006. International analysts have warned that Bulgaria's growing external deficits render its economy vulnerable to exogenous shocks. While booming domestic credit has supplied money for an under-capitalized economy, it also has heated up certain sectors of the economy, such as the real estate market, while at the same time increasing debt levels. In the absence of effective monetary authority given Bulgaria's currency-board arrangement, tight fiscal policies remain the principal working instrument to control public wages, inflation and further deterioration of the external sector. END OF SUMMARY INTERNATIONAL ANALYSTS RING THE BELL 2 (U) According to a recent World Bank report, in some countries--most notably Latvia but also the other Baltic countries, Bulgaria, and Romania--booming domestic demand is leading to overheating and current growth rates are unlikely to be sustainable. Danske Bank earlier said it is expecting a less optimistic outlook of the Bulgarian and Romanian economies by international credit agencies due to a lack of progress in EU-related reforms and "continued rise in the external imbalances." The IMF has similarly drawn attention to Bulgaria's rising external debt, which reached around 80 percent of GDP last year. EU-PHORIA DRIVES HIGH GROWTH AND CURRENT ACCOUNT DEFICIT ¶3. (U) Euphoria related to Bulgaria's EU accession has led to high and steady economic growth--over 5 percent on average in the last 7 years--driven by buoyant consumption and investment activity. While the strong domestic demand reflected expectations for deeper EU integration and rising incomes, it also caused a large expansion of trade and current account (CA) gaps. The CA deficit tripled over the last three years to 15.8 percent of GDP in 2006, while the trade gap rose to 21.5 percent of GDP. The first quarter of 2007 reconfirmed this negative trend with CA deficit growth of 5.6 percent of GDP. The deficit in April grew even further to 8 percent of GDP for the quarter. Government officials and some analysts argue that a new EU requirement has led to a notable underreporting of exports. CA DEFICIT PROJECTED TO GROW ¶4. (U) The IMF projected further growth of the CA deficit to 16.6 percent of GDP this year, slowing to 16.2 percent in 2008. Finance Minister Oresharski was less optimistic, saying the deficit this year might grow to 18 percent of GDP. Local media speculated that Oresharski, who is known for his conservative fiscal positions, might have intentionally over-stated the figure in an effort to stem some ministers' demands for increased budget spending. LARGE DEFICITS FED BY MORE FOREIGN INVESTMENT ¶5. (U) As is typical for an open and undercapitalized economy, Bulgaria's growing CA deficits have been increasingly financed by outside money and capital. This has been facilitated by a liberalized investment regime and higher investor confidence in the run-up to EU membership. Foreign direct investments (FDI) grew to a record high in 2006, adding to a strong financial account that managed to cover last year's CA deficit (103.2 percent). The growing foreign investments help build up a stock of investment goods--a third of last year's imports--which while exacerbating the trade balance, is helping the higher capitalization and more sustainable growth of the economy. According to analysts from the Institute for International Finances, based in Washington, D.C., new capital growth has been too strong in recent years--over 18 percent on average in the last three years--and the need for some "cooling" has already arrived. OVERHEATING OF REAL ESTATE - QUITE STRONG AND RISING ¶6. (U) The level of corporate and household credit reached 39.6 percent annual growth in April. This concerns the central bank, which removed administrative barriers to credit growth at the beginning of this year and has no intention to re-impose them. The increased money supply created more liquidity and strong inflationary potential in some sectors of the economy, most notably real estate. While consumer prices saw an average annual increase of 7.3% in 2006, housing prices rose 14.7 percent. Prices in the real estate market are likely to surge as demand for housing remains stable, while there is ample room for mortgage loans to grow. This could lead to the accumulation of new household debt, which has grown 40.1 percent year-on-year in the first quarter of 2007. The level of corporate debt is also raising concern, as it increased to 49.1 percent year-on-year in May reflecting local firms' increased needs for financing their investment activities. SOFIA 00000828 002.2 OF 003 HIGHER EXPORT COMPETITIVENESS WOULD HELP EXTERNAL POSITION ¶7. (SBU) Bulgaria's high CA deficit reflects a loss of competitiveness on the export side. With investment and consumption needs likely to remain high over the mid-term, the Bulgarian economy needs to advance its export capacity to become less vulnerable to external shocks. But a fixed exchange rate--with the Bulgarian Lev currently anchored to the Euro under the currency board regime--makes export-led growth more difficult. Some financial analysts believe the Bulgarian currency is overvalued and impeding any export-led momentum. Neither government officials nor international financial analysts we spoke to support a devaluation of the Lev in order to stimulate export growth. But all agreed that the economy was becoming too dependent on foreign money and capital to cover its external deficits. BUFFERS SAFEGUARD CURRENCY BOARD ¶8. (U) A number of strong buffers currently shelter the currency board against external risks. The GOB's prudent fiscal policies have helped build up large fiscal reserves (5.8 billion leva or USD 4 billion at end-2006) after three consecutive years of surplus budgets. The government has promised to hold the line--targeting a 2 percent surplus this year--and will not spend the last 10 percent of its budget this year if the CA deficit target of 11.8 percent of GDP is not met. Foreign exchange reserves at the central bank continued to grow, reaching 17.5 billion leva (USD 12 billion) at end-2006, and covering almost 170 percent of the domestic money base and over 5 months of last year's imports. Additionally, further economic and financial convergence with the EU will provide the most effective protection against external pressures on the local currency in the run-up to Euro-zone membership. "HOT MONEY" CLOSE, BUT NOT YET FULLY IN BULGARIA ¶9. (U) "Hot money" or currency speculators, who come in and out of the market quickly, have not yet been attracted to Bulgaria. But equity funds are now aggressively building up portfolios of high risk capital, ready to sell it for quick and high premiums. A recent shake up in China's capital markets resonated slightly in Bulgaria, with both domestic market indices registering a slump. Due to their large loan portfolio and tight capital adequacy, local banks have little free cash to be able to make short-term loans with high-risk premiums, which should reduce the exposure of the banking system to the risks of speculation. Foreign banks own 80 percent of the banking system, which is another liquidity buffer against a systematic run. Banks have joined efforts with portfolio capital to develop mutual funds for financing new high-risk ventures. In an effort to the test the resilience of the local banking system, the EU plans to implement an EU-wide project by year's end that will gauge how monetary authorities react to an individual bank failure. NO "LANDING" ON HORIZON ¶10. (SBU) The local economy is expected to grow over the next couple of years, led by an upsurge in domestic consumption and investment. A 6.2 percent GDP growth in the first quarter of 2007 is leading economists to argue that the overall growth for the year will reach beyond 6 percent. Strong domestic demand will keep pressure on prices, but inflation is projected to decline to an average of 4.4 percent this year from 7.3 percent in 2006, as output expands and no one-off administrative price spikes are anticipated in 2007. Government officials told us this projection will be revised upwards to include a 7.5 percent increase in electricity prices as of July. PAY AS YOU GROW ¶11. (SBU) Booming consumption points at much higher wage growth in 2006 than the officially announced 9.6 percent. Currently, the government is facing pressure for wage increases from some public-sector servants, such as teachers, medical and social workers. The GOB must continue to adhere to prudent fiscal policies and ensure that any future wage increases go hand-in-hand with at least equal gains in labor productivity--now at a third of the EU-average. If it does hold down public sector wages, the gap between public and private-sector wages will continue to grow, increasing the likelihood of labor unrest in the public sector, signs of which began to appear in recent months. The current Socialist-led government is well aware that such unrest sparked the downfall of the previous Socialist government in 1996-97. COMMENT ¶12. (SBU) The GOB has taken advantage of its improved public finances to ease inflationary pressures and avoid any external shocks. It should now closely track a few potential bad apples that SOFIA 00000828 003.2 OF 003 could quickly spoil the country's strong economic growth. Persistent consumption (rather than export)-driven growth, real estate price bubbles, and inflation--the only unmet Maastricht criterion for Euro-zone membership--should remain on the government's watch-list. Despite the strong pace of capitalization, the Bulgarian economy is not able to sustain its growth based solely or mainly on new debt and outside money, which often is seeking quick profits. Bulgaria must guard against abrupt changes in investor sentiment while ensuring continued strong growth. At the same time, the government must keep looking over its shoulder at increasingly restless teachers, healthcare, transport, and other public sector workers. END OF COMMENT BEYRLE