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S&P raises Bulgaria's ratings to 'BBB/A-2', outlook positive

Author Mario Tanev
S&P raises Bulgaria's ratings to 'BBB/A-2', outlook positive gary yim/Shutterstock.com

SOFIA (Bulgaria), December 2 (SeeNews) - Standard & Poor's (S&P) said it has raised its long- and short-term foreign and local currency sovereign credit ratings on Bulgaria to 'BBB/A-2' from 'BBB-/A-3' with positive outlook.

S&P also raised its transfer and convertibility assessment to 'A' from 'A-', it said in a statement on Friday.

The positive outlook is based on the ratings agency's view that Bulgaria is expected to continue to progressively strengthen its fiscal and external position, as the country grows resiliently in a weaker external economy.

S&P also said in its statement:

"We could raise the ratings if Bulgaria's economy continues to grow resiliently without reversing fiscal gains or if the country's external performance strengthened beyond our expectations. We could also raise the ratings if Bulgaria further entrenches structural and institutional improvements, for example on its path toward euro adoption.

We could revise the outlook to stable if we observed external financing pressures or the buildup of significant macroeconomic imbalances.

Rationale

The upgrade reflects that we expect Bulgaria's economy to grow resiliently and post strong fiscal results. At the same time, we think that the country has completed its own deliverables under its action plan toward ERM II and Banking Union membership, but the ultimate accession decision is not fully in its control. We believe that institutional convergence has progressed, for example through the alignment of legislation, the implementation of EU legislation on the central bank and macro-prudential supervision, amending the insolvency framework, the framework for state-owned enterprise (SOE) management, nonbanking supervision, and the anti-money-laundering framework.

Compared with five years ago, Bulgaria's net government debt is six percentage points lower, the current account is in a strong surplus compared with a roughly balanced current account in 2015, and net external liabilities have nearly halved over the past five years.

Low government and private-sector debt, and the recent current account surpluses that facilitated external deleveraging, provide Bulgaria with buffers if an external shock were to arise. At the same time, growth has not been coupled with the buildup of significant macroeconomic imbalances. Despite a tightening labor market, we think that external competitiveness has continued, because the country's share in world trade has risen over recent years. Bulgaria's fiscal position has improved markedly over the past few years, with surpluses in 2016-2018 and likely in 2019, after a general government deficit of 5.4% of GDP in 2014. These fiscal gains follow strong revenue due to the cyclical recovery, as well as improved tax collection and some under-implementation of investment spending. We expect the strong fiscal position to persist given the authorities' track record of prudent fiscal policy.

Our ratings on Bulgaria reflect the country's prudent fiscal policy and very low government debt. The ratings also take into account the strong external balance sheet and recent years of current account surpluses. We also factor Bulgaria's limited monetary policy flexibility under its currency board arrangement into our analysis, although the board has provided an important anchor of stability for the country. The ratings are still constrained by remaining institutional impediments and the country's low GDP per capita in a European comparison.

Institutional and economic profile: The economy is expanding robustly, but demography remains a long-term growth challenge

Growth will slow from 2020, but remain supported by domestic demand.
Bulgaria's EU membership is an anchor for institutional convergence, in our view.
Demographic challenges and structural constraints will drag on potential growth.

We project that the Bulgarian economy will expand by 3.6% in 2019, slightly higher than our previous forecast. This reflects strong private consumption due to employment and wage increases. On the other hand, we expect weaker external demand will weigh on growth in the second half of this year. In the coming two-to-three years, we expect the Bulgarian economy to grow resiliently, albeit more moderately. Growth will average about 3% in 2020-2022, mainly because of domestic demand. We still expect robust private consumption as real wage increases continue, not least due to minimum and public-sector wage hikes, and we think that EU fund absorption will accelerate toward the end of the current multiannual financial framework (MFF), thereby propelling investment growth in 2021-2022. External demand from main trading partners is likely to be more subdued in the coming years, so we expect exports to increase moderately. And the cyclical slowdown will help cool the tight labor market.

We expect unemployment to drop to a historical low of 4.4% in 2019. In the coming years, however, employment growth will fade due to Bulgaria's shrinking working age population. We think that demographic challenges will pose a drag on potential growth, as the country's labor force continues to shrink due to aging and emigration.

In our view, Bulgaria's demographic challenges also highlight the need for continued structural reforms. For example, measures to address skill mismatches could at least partially alleviate the labor shortage. Continued structural reforms, such as sustainable efforts to improve judiciary system efficiency, could benefit the business environment, spur income convergence, and contribute to slowing net emigration. Furthermore, it remains crucial, in our view, to further lend credibility to the reformed anticorruption legislation by building a track record of fighting illicit activities. We note that Bulgaria's progress in these areas has been acknowledged under the European Commission's Cooperation and Verification Mechanism.

The latter is also important because under the EU's new MFF, new standards could factor in rule of law criteria. The draft 2021-2027 MFF proposal incorporates a nominal 8% increase of total funding for Bulgaria. We think that the current MFF for 2014-2020 will support investments in the coming years as EU fund absorption is usually skewed toward the end of the programming period, with an additional three years to spend allocated funds after its end. In the current period, allocated funds for Bulgaria amount to over 20% of GDP, and the absorption rate has reached almost 40% as of October 2019.

While falling unemployment has translated into robust wage growth in recent years (nominal year-over-year wage growth was about 12% as of third-quarter 2019), we do not expect this will endanger cost competitiveness, not least because labor costs are still the lowest in the EU.

We think that the current government coalition of the center-right GERB and the United Patriots could serve its term until 2021, absent major detrimental events. This is because GERB has solidified its position in the European Parliament and the local elections, and appetite for early elections seems low among the coalition partners. In the past, however, we have observed episodes of political volatility in Bulgaria. We think that important issues, such as the country's ERM II accession, have political consensus across the spectrum, and therefore provide an important policy anchor.

Flexibility and performance profile: Fiscal and external surpluses provide substantial buffers

We expect Bulgaria's strong fiscal performance to continue, with balanced budgets on average in 2019-2022.
The current account will stay in surplus during that time.
The country is on its way to join ERM II and the Banking Union next year, subject to the partner countries' and institutions' approval.

Bulgaria has posted general government surpluses over the past three years, driven by fiscal prudency, rising tax collection, and the strong economic performance. Tax revenues have increased by over 40% from 2014-2018, well above nominal GDP growth of about 30%. For 2019, we now expect a small surplus, reflecting another year of tax revenue outperformance and unallocated spending. We now project that the government will post approximately balanced accounts in 2020-2022. This is despite our anticipation that expenditures are set to rise, for example on public sector and specifically teachers' wages, not least to facilitate income convergence with the rest of the EU.

Bulgaria's government debt is low, and we expect government debt net of liquid assets to decrease to below 10% of GDP by 2022 from 12% in 2019. We expect that the government will retain its sizable liquid assets over the coming years to provide buffers for upcoming bond maturities after 2021. The low debt burden grants the country fiscal space to respond to external and domestic shocks and the materialization of contingent risks, should they arise.

In the past, the energy sector has been a source of contingent fiscal risk. Several SOEs in the sector, including Natsionalna Elektricheska Kompania, have incurred losses thus far in 2019, against the trend for SOEs in general. The government has launched a process to revive the Belene nuclear power plant project, without financial support from the government, and is to choose among the investors' bids in the coming months.

Bulgaria's strong track record of fiscal prudency is also tied to its currency board regime, which fosters fiscal stability because it crucially underpins the arrangement's credibility. In 1997, the country introduced a currency board regime, which effectively guarantees the convertibility of lev into euros (originally deutschemark) at a fixed exchange rate. Over the past two decades, authorities have accumulated fiscal and external buffers to underpin their commitment to the fixed exchange rate regime. That commitment has not wavered, despite a series of external and domestic political shocks, since Bulgaria's 2007 accession into the EU. The country's foreign currency reserves cover the monetary base by about 1.6x as of September 2019. As per its charter--and according to the currency board regime under which it operates--the Bulgarian National Bank's (BNB) ability to act as a lender of last resort is limited. BNB can provide liquidity support to the banking system only to the extent that its reserves exceed its monetary liabilities. Even then, support can occur only under certain conditions and for short periods, against highly liquid collateral. The board lowered inflation and prevented further episodes of hyperinflation. We project harmonized CPI will average 2.3% in 2019-2022, as favorable commodity price developments counterbalance rising domestic price pressures from higher incomes and rising credit.

We project Bulgaria's current account will post a strong surplus in 2019, which will only gradually decrease to below 2% of GDP by 2022. While weaker external demand from Bulgaria's European trading partners will affect Bulgarian exports, we note that Bulgaria's services exports (for example tourism, business services, and information and communication technology services) have been resilient in 2019 and strong remittances inflows continue to support the secondary transfers balance. Contrary to our previous forecast, we expect the current account to remain in surplus over 2019-2022. We also expect Bulgaria to remain in a net external asset position by our measure of narrow net external debt, to the tune of almost 50% of current account payments on average in that time. Gross external financing needs are set to hover at slightly over 100% of current account receipts and usable reserves.

We still project net foreign direct investment will average less than 2% in the coming years. This reflects generally lower capital flow and high savings, but removing perceived impediments to the business climate could also contribute to reviving direct investment flows. Also, foreign direct investment in the manufacturing sector has been positive in recent years, a key difference to the high pre-2009 inflows into real estate investment, which contributed to the build-up of macroeconomic imbalances. In addition, the structure of Bulgarian exports now shows a much higher share of machinery exports versus lower value-added goods. Bulgaria's tourism sector has benefited from instability in competing destinations, contributing to a strong surplus of the services balance.

Bulgaria aims to enter ERM II, the waiting room for eurozone membership, next year. In its application last year, the country committed to join ERM II and the Single Supervisory Mechanism simultaneously.

Bulgaria has made significant progress in fulfilling its commitments for ERM II accession. We understand that the key remaining issue is addressing the capital needs at two domestic banks, which the ECB identified in this year's asset quality review. This is necessary in preparation of close cooperation between the Bulgarian National Bank and the ECB, and the country's integration into the Single Supervisory Mechanism which Bulgaria committed to join at the same time as the country enters ERM II.

We think the ultimate ERM II accession decision and timeline crucially will hinge on political considerations not necessary within Bulgaria's control, because the eurozone and Denmark's finance ministers, and the ECB, will decide. While Bulgaria's performance under quantitative criteria is strong, support elsewhere in Europe could hinge on the perception of institutional convergence and the strength of the banking sector. However, political considerations aside, we think that the country's progress so far will enable it to join the ERM II in 2020, which would support our view of the credibility of its monetary policy framework.

On its path to ERM II accession under the government's action plan, Bulgaria has implemented measures in a wide array of sectors: for example the implementation of EU legislation on the central bank and macroprudential supervision, amending the insolvency framework, the framework for SOE management, nonbanking supervision, and the framework for anti-money laundering.

Credit to the private sector grew by 6% year-over-year in August, with corporate credit expanding by 3.3% and credit to households increasing by 8.8%. Nonperforming loans in the banking sector amount to 7.4% of total loans as of September 2019. This is a slight increase compared to June, but still significantly down from the two-digit percentage recorded at the end of 2017.

The Bulgarian banking sector is profitable and generally adequately capitalized. With the transposition of the EU Banking Resolution and Recovery Directive in 2015, the failure of a bank will necessitate a bail-in of shareholders, creditors, and then--if necessary and under certain conditions--a resolution fund. Only after exhausting these options and in an extraordinary situation of a systemic crisis would a bank be able to resort to government support. The BNB has consistently implemented measures to ensure the stability of banks (including subsidiaries), among other measures by strengthening their liquidity and capital buffers. Plans to raise additional capital by two domestic banks, needed because of the recent stress test, seem manageable.

The BNB earlier this year announced a further increase in the countercyclical capital buffer effective April 2020 (it already increased as of October 2019), as a stock-based measure to safeguard the system from cyclical risks linked to credit growth and real estate price growth. The close cooperation procedure under the auspices of the ECB will also lead to further alignment of supervisory practices as the country moves toward joining the Banking Union."

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