EMERGING BULGARIA 2004
PRUDENT POLICY WINS THE DAY
The painful reform programmes are finally beginning to bear fruit

As 2004 begins, Bulgaria seems in fine macroeconomic fettle. Economic growth is brisk, inflation low, the budget balanced, foreign investment at record levels, debt ratios improving and unemployment – though still high – down sharply. True, key privatisation deals remain stubbornly unfinished, trade and current account deficits high and living standards low. But Bulgaria seems set on a smooth course as it moves towards the European Union membership it hopes to achieve in 2007.

It was not always thus. The first eight years of transition to a free-market economy were turbulent indeed. Heavily indebted and unusually geared towards Soviet markets and subsidies, Bulgaria suffered t umbilical cord was cut, aggravated by the effects of a debt moratorium in 1990. Rescheduling was achieved in 1994, but more woes followed. Over-accommodating banks, unrestructured state industry and ill-advised growth policies produced a banking crisis, galloping inflation and the spectacular crash of both the national currency and the Socialist government in late 1996.

Its right-of-centre successor, headed by Ivan Kostov, adopted the draconian stabilisation remedy recommended by the International Monetary Fund – the currency board arrangement (CBA) – to replace the previous free-floating exchange rate. The CBA fixes a permanent rate against a selected currency, then guarantees it by strictly linking money in circulation to the level of forex reserves held by the central bank, which is obliged to buy the local currency at that rate. The rate was Lv1000:DM1 when the currency board was introduced. This has been maintained since, though redenomination of the lev in mid-1999 and the Euro’s replacement of the Deutschmark mean the rate is now Lv1.95583:Euro 1.

The following years saw stability maintained. Inflation, restrained but not ruled out by the CBA, fell dramatically, from 312% and 548% in 1996 and 1997, to 1.6% in 1998 and between 4.8% and 11.3% in 1999-2001. Budget deficits ran at or under 1% of GDP. GDP itself resumed growth after a 14.5% decline in 1996-1997, reaching 1995 levels again in 2001. Extensive privatisation and restructuring cut back the problematic state industrial sector.

Unemployment rose, however, peaking at 19% in April 2000. Bank lending remained low. And, in popular perceptions at least, economic growth failed to translate into a quick enough rise in living standards. This public discontent in part led to the victory of the new National Movement for Simeon II (NMSII) in June 2001 elections.

2003 SITUATION: Things have gone fairly well on the NMSII’s watch. It started unpromisingly after the September 11,2001, attacks on the United States and fears of global recession. But GDP grew 4.8% in 2002 and perhaps not much less in 2003. Nine-month growth in 2003 was 4.2%. A poor harvest sent farm output down 1.9%, but was more than offset by brisk industrial growth of 7.3%. Most industrial branches shared in this surge, though food processing, textiles, footwear, wood and paper, rubber and plastics, electrical machinery, communications equipment, and furniture production surged more than the average.

Booming exports explain much of industry’s dynamism in a country heavily export-oriented. They nudged $6.2bn in the first 10 months of 2003, up 32% on 2002. A weaker dollar means euro-denominated growth of 11% is less misleading, but still impressive, coming on the back of three years of brisk growth. Exports in 2002 rose an annual 42.1% in dollar terms and 62.4% in Euro terms. It’s also impressive given sluggish growth on world markets and the dollar’s depreciation, which should have affected Bulgaria’s Euro-linked competitiveness.

That it apparently didn’t suggests Bulgarian industry is competing on something other than low wage costs. Of commodities, clothing and footwear, metallurgy and oil products were the biggest exports – the first two on an upswing in 2003. Geographically, EU markets predominated as usual, with other OECD countries and fellow Central European Free Trade Assocation (CEFTA) countries well behind. Sales to once key former Soviet markets, meanwhile, continued a long slide into insignificance.

If exports rose fast, 10-month imports rose faster, by 16.4%. This was partly due to investment growth. Capital –goods imports grew somewhat more than average. But it was also partly a matter of Bulgarians’ appetite for foreign consumer goods, imports of which grew almost as quickly.Nine-month real growth of 3.8% in retail sales also speaks to a minor consumer boom, though respective growth rates suggest importers, rather than local producers, are benefiting most.

Durables are selling especially well, partly on the strength of consumer credits from banks, whose volume grew 66% in the first half of 2003 alone. Fast import growth widened the trade deficit to a record $1.786bn (fob/fob), 68.6% up on the first 10 months of 2002, in dollar terms. This in turn pushed up the current account (C/A) deficit from $222m to $1.043bn, despite a brisk, record-breaking rise in tourism revenues.

Given normal seasonal patterns, these should translate into annual deficits of perhaps $2.5bn for trade and $1.5bn for the C/A – high enough to cause concern, but hardly despair. A C/A deficit around 7.5% of GDP is not outrageous for a transition country. Bulgaria’s forex reserves are high, well above CBA-required levels, and rising (up Euro918m y-o-y by end-October 2003). Most importantly. FDI inflows are on the rise, offsetting the increased C/A deficit.

FDI set another record. At $1.273bn, the 10-month total FDI already exceeded the previous 12-month high of just over $1bn in 2000. It was achieved despite the lag in large privatisation deals – only one large sale figured in the total, DSK bank’s sale to Hungary’s OTP-and mostly as additional investment by those already in Bulgaria. Unimpressive by Hungarian or Czech standards, it is very encouraging by Bulgarian ones and fits with a rising trend in fixed investment generally. This rose a real 17.2% in the first three quarters of 2003, following a 2.5-fold increase between 1997 and 2002. Fixed investment is still a low 20% of GDP. But things are beginning to move.

Striking, too, is the recent drop in unemployment. The November-registered total was 490,000 or 13.2%, down from 16.9% a year earlier, thanks to an economic upturn and determined job-creation schemes. True, 13.2% is still high. And some estimates put the rate of those unemployed for one year or longer at some 54%.

It is also important that none of this has been achieved at the cost of high budget deficits or serious inflation. In fact, 2003 is likely to have seen a zero deficit, with an original target equivalent to 0.7% of GDP, brought down to rein in the burgeoning C/A gap. The ability to do so derived from revenue over-shoot rather than spending cuts, admittedly, but is still impressive, especially in a local election year. As for inflation, November’s was a manageable 5% y-o-y, with higher farm prices and administered price-hikes explaining most of it.

REFORM AND RESTRUCTURING: Reform progress has been considerable. Around two-thirds of state assets were denationalised under Kostov (albeit with too much emphasis on management buyouts and second-rate investors,for some tastes). Prime Minister Simeon Saxe-Coburg was left with politically trickier sales, like telecoms company BTC and tobacco giant Bulgartabac, neither of which have yet been concluded. The last two banks in state hands have been sold, however, while the stock-exchange privatisation of many state-owned enterprises’ (SOEs) with minority packages is at last proceeding. A major energy privatisation drive was launched in late 2003, when the country’s seven power-distribution companies were put on sale and a liberalising energy law was passed in December.

The government has made a series of painful houshold energy price hikes designed to eliminate wasteful cross-subsidies, the last scheduled for mid-2004 . Financial sector reform was essentially accomplished by the destructive crisis of 1996-1997, CBA discipline and tough supervision, and the sale of all surviving state-owned banks to foreign buyers. Real sector privatisation and closures under Kostov mean the problem of “black holes” – large loss-making, heavily indebted SOEs-is confined to the railways and one defence producer.

The IMF and World Bank have been central to the reform process since the early 1990s, exerting pressure, which explains much of the progress since 1997. Ample forex reserves and the growing ability to tap international markets make multilateral cash much less necessary to Bulgaria than it used to be. The two-year IMF stand-by agreement to be negotiated in early 2004, in fact, will be “precautionary”; any disbursement of IMF funds will only occur if deemed necessary. With multilateral approval still important for market and investor perceptions, however, the government appears anxious to keep that approval. A left-wing successor might be yet more anxious.

Despite periodic tensions, IMF approval has generally been forthcoming – at least after 1997, when Bulgaria swapped delinquent for “model pupil” status. The country is now completing a two-year $300m IMF stand-by agreement.

There have been no serious tiffs lately, but IMF concerns about the C/A and credit growth led, respectively, to fiscal tightening and strengthened credit supervision. The IMF has, however, been relaxed over proposals to use reserve funds for infrastructure projects and a target 2004 budget deficit of 0.7% (the IMF had wanted 0.5%).

The central World Bank agreement at Present is for a three-year, three-tranche $450m Programmatic Adjustment Loan (PAL). The first year concentrated on growth, employment and poverty reduction, and the second year centred on public administration, the judiciary and anti-corruption initiatives.

The final year will focus on human capital and the improved delivery of social services, while other World Bank agreements concern areas such as energy efficiency, forest strategy and secondary roads. Like the IMF, the World Bank has generally been appreciative recently, but stresses the need to solve the Bulgartabac question before the second PAL tranche is disbursed. Pressure to rationalise the state railways has been in evidence from both the World Bank and the IMF.

Rating agencies are fairly impressed as well. Currently, Bulgaria is rated at BB+(outlook stable) by Standard & Poor’s, Ba2 (outlook stable) by Moody’s Investor Services and BB+(outlook positive) by Fitch.. These ratings are nudging the investment-grade status that has already been granted by Japan’s JCRA. Between them, the four rating agencies gave Bulgaria no less than 10 upgrades in the government’s first two years. Small wonder, since the country’s debt position is pretty solid. Total debt represented around 80% of GDP at end-2000, but only around 55% at end-2003 (partly because the CBA has meant a rapidly rising nominal GDP). The “fiscal reserve” of forex in excess of CBA requirements – designed to reassure creditors of debt-service capabilities – stands at around double the intended reassurance level, and some of it is likely to be used for debt reduction in 2004.

MOVING TOWARDS EUROPE: EU membership aspirations have been central to policy since early transition. A Europe Agreement came into force in 1995; formal membership negotiations started in 2000. Unlike its “second wave” colleague Romania, Bulgaria has received recognition (in late 2002) as a “functioning market economy”, and talks have gone quite swiftly. By end-2003, Bulgaria had opened 30 of 31 negotiating chapters and provisionally closed 26 (compared to Romania’s 22). Those still open are: finance/budget, regional policy, competition and agriculture (the miscellaneous “other” chapter remains unopened). Bulgaria hopes for membership at the start of 2007, a hope reinforced by a statement of the Brussels meeting of EU government heads in December 2003, which supported accession by Bulgaria and Romania in January 2007 “if they are ready”, called for completion of their negotiations in 2004 and the signing of an accession treaty in 2005, and urged the European Commission to provide at the beginning of 2004 the financial framework needed for talks on the remaining chapters.

This was as favourable a statement as could reasonably have been expected, but some doubts remain. One concerns Bulgaria’s bracketing with Romania, which might entail delays. So might greater-than-expected difficulties in assimilating the 10 countries acceding in May 2004 or general wrangling over the EU constitution.

Bulgaria’s nuclear power station at Kozloduy could also pose a problem: Brussels is adamant that Units 3 and 4 should be shut down at end-2006 on safety grounds. The government effectively conceded to the demand by closing the Energy Chapter in September 2002, an unpopular decision whose legality has been questioned. If domestic pressure led to the chapter’s reopening, the accession process could be disrupted.

Meanwhile, even a favourable scenario involves much pre-accession work. The Brussels declaration included a familiar “to-do” list, including judicial reform, further struggle against corruption, respect for human rights and minority protection (a reference to Bulgaria’s Roma minority), and development of the administrative capacity needed to apply the EU’s acquis communautaire in agriculture, senvironment and regional policy. As European Enlargement Commissioner Guenther Verheugen’s summer ultimatum shows, EU officials have not hesitated to chivvy Bulgaria along in areas where it lags.

The declaration also called for the development of a capacity to manage pre-accession funds. It has a point: around Euro1.2bn worth of aid will be available between 2004 and 2006 under PHARE and the agricultural and infrastructure SAPARD and ISPA programmes. Shortcomings in using it are already prompting
intensive finger pointing within the coalition.

PROBLEMS, PROBLEMS: A generally positive assessment should not give the impression that Bulgaria lacks problems. It has plenty. For instance, living standards may be rising, but they are on average still pitifully low. The figures of the National Statistical Institute imply household consumption growth of around 15% since 2000 and almost 35% since the annus horribilis of 1997. But the average monthly salary in the third quarter of 2003, according to official statistics, was Lv282, a paltry Euro 144. A thriving grey economy means the actual figure may be 50-70% higher, but that still represents no great wealth.

Another example is corruption. Sociological surveys and international comparisons suggest that the level of corruption in Bulgaria has declined very significantly over the last six years or so and that the country does not compare unfavourably with central European states like Poland and Hungary. Yet a recent survey by the anti-corruption non-governmental organisation Coalition 2000 revealed that 53% of firms saw corruption as the main problem facing business.

Then there’s healthcare. Bulgaria started the move from a communist-era health system to an insurance-based one more than four years ago, and the transition has been reasonably successful in the sphere of primary healthcare. Restructuring has been slow in the hospital sector, however, and the situation in provincial hospitals is one of shortages and financial muddle. Drug reimbursement is also chronically underfunded, with large emergency subventions regularly required to set the books straight, despite a restricted entitlements budget.

Examples might be multiplied. Bulgaria is making progress, but there’s some way to go before the picture becomes rosy.

OUTLOOK: The budget for 2004 is optimistic in assumption and expansionist in substance. Faster GDP growth of 5.3% is assumed, along with somewhat lower inflation of 4% and a C/A deficit of 6.2%, considerably under the likely 2003 out-turn. While a consolidated budget deficit of Lv237m(0.7%) is targeted, off-budget expenditures of almost Lv900m in highways, forestry, agriculture and environment arguably bring the effective deficit up to 3.05% of GDP . Discussions with the IMF produced plans to hold back if the C/A deficit looked like it was getting out of control.

Whether these pledges can hold in a pre-election year and under serious pressure from the Movement for Rights and Freedom (MRF) party is an interesting question. Economic risk factors exist too. Such a high growth rate perhaps presupposes an international environment more favourable – and Bulgarian industry more competitive – than may prove to be the case.

Whatever the precise figures, there’s little reason to doubt that Bulgaria will continue to perform impressively. The encouraging FDI total for 2003 is unlikely to be a one off. It shows increasing confidence in the Balkan nation from the investors best placed to judge-those already in place.

It also shows what is possible even while big privatisations stall and energy investments has yet to start in earnest. Most likely 2004 will see substantial progress in both respects. Similarly, Bulgarian exporters’ performance in the context of a sluggish international economy and an over-strong Euro suggests competitiveness is already improving. Investment, foreign and otherwise, will improve it further.

Finally, rising imports of consumer goods and consumer credit volumes are not just a source of current account embarrassment. They are also a sign Bulgaria is beginning to address a long-standing foreign investor complaint: the absence of a buoyant local market. True, not all of the population is enjoying the effects of that buoyancy. True also, Bulgarians – a pessimistic lot – may not recognise improvement as soon as they see it. But it’s a start. As long as stability is preserved, things can only get better.