December 5 (SeeNews) - Standard&Poor's Ratings Services said it affirmed its 'BB+/B' long- and short-term foreign and local currency sovereign credit ratings on Bulgaria with a stable outlook.
"Bulgaria’s economic recovery has been accelerating so far in 2016, alongside improvements in the labor market, a narrowing government budget deficit, and a current account surplus," the ratings agency said in a statement late on Friday.
"The stable outlook reflects our view that the government’s still-moderate debt burden with ample fiscal space balances the risks of a potential weakening of the external environment, a re-emergence of risks in the financial sector, and the prevalent political uncertainty," it also said.
S&P also said in the statement:
"The ratings remain constrained by Bulgaria's relatively low income levels, with GDP per capita estimated at $7,200 in 2016. They are also constrained by the government and central bankauthorities' limited policy flexibility due to the country's currency board regime and the high--albeit decreasing--proportion of loans and deposits denominated in euros, hampering the effective transmission of monetary policy regarding credit to the real economy. A further constraint is the weak institutional setting, where progress on the reform of the judiciary has been slow--an area that would be key for strengthening the business environment.
The ratings are supported by the government's moderate net debt position, projected at 18% of 2016 GDP. They also benefit from Bulgaria's moderately leveraged external balance sheet following half a decade of external deleveraging, led primarily by the financial sector. That said, credit growth, especially to the corporate sector, remains subdued although there are tentative signs of a recovery--notably mortgage lending has been increasing in 2016 in line with better labor market indicators.
Following the government’s resignation in mid-November, Bulgaria is facing uncertainty about the future path of economic policy. We view it as highly likely that early elections will be called for spring 2017 and a caretaker government will come into office until the snap elections. The transition in the president’s office following the recent presidential elections--which was the external trigger for the government’s resignation--will, in our view, not greatly affect the caretaker administration in the next few months, nor will it affect the day-to-day politics of a new government.
That said, this political impasse adds to the experience of frequent government changes in Bulgaria over the past few years. We expect that political uncertainty will remain elevated leading up to the probable snap elections and the outcome might not lead to higher government stability, given the likely strengthening of smaller political forces adding to an already fragmented political landscape. In the next few months, political considerations could lead to a looser fiscal stance, or electoral promises regarding higher spending beyond the priority are as identified by the outgoing government such as health care and education. Additionally, a political standstill could weigh on private sector investment decisions and consumption and therefore hurt the ongoing recovery.
That said, economic recovery in Bulgaria has gained momentum over 2016, underpinned by sound net exports and increasing private consumption. At the same time, we expect employment will grow by around 1% in 2016 and the unemployment rate will further decrease to around 8% by year-end--well below the 13% recorded three years ago but still above pre-crisis levels. Despite the political uncertainty, we expect growth to persist in 2017 as we anticipate sound net exports and increased domestic demand with rising disposable incomes to persist. With the beginning of the new EU budget cycle, public investment projects financed by EU structural and cohesion funds will also be an important contributor to economic performance, following the break in 2016 due to the previous programming period ending. We understand that policy-makers are well prepared to absorb the maximum possible amount from the available funds. We also expect Bulgaria’s deflationary trend to end in 2017 when we project core and headline inflation to return to positive.
Bulgaria's moderate government debt burden (net of liquid assets) affords the country fiscal space to respond to external and domestic shocks, should they arise. This is all the more important given Bulgaria's currency board arrangement, which acts as an important nominal anchor, but affords minimal monetary policy flexibility. Bulgaria posted a particularly strong budgetary performance in 2016, and we expect the deficit in accrual terms to narrow to 0.8% of GDP from 1.7% of GDP in 2015, supported by measures to widen the tax base and improve collection and especially lower investments as the EU programming period came to an end.
We expect this deficit to reduce further to 1.2% of GDP by 2019. Risks for fiscal consolidation in the near term mainly stem from the political situation as the likely electoral campaign may induce a looser fiscal stance in the coming months.
We expect that gross general government debt will remain roughly stable at just below 30% over the forecast horizon, reaching 28% of GDP by 2019. We note that about 80% of total government debt is denominated in foreign currency, mainly euros.
Although the government has sizable deposits that increased with its March 2016 Eurobond issuance, there are still significant fiscal risks stemming from contingent liabilities associated with Bulgaria’s state-owned enterprises. Contingent liabilities that could materialize include those from the energy sector, although the government has recently succeeded in reducing losses at Natsionalna Elektricheska Kompania (NEK). However, the government has decided to provide financing following the arbitration court decision on NEK--to compensate Russia-based Atomstroyexport for equipment already produced for the cancelled Belene nuclear power plant. The government is waiting for the European Commission’s decision on compliance with state aid procedures before it provides the financing of 1.4% of GDP to NEK.
Following the recent publication of the results of this year’s Asset Quality Review, the banking sector is adequately capitalized. However, two domestic institutions have to replenish their additional capital buffers by spring next year. Most prominently, we understand that as an outcome of the stress test's adverse scenario, First Investment Bank, the country's third-largest bank, needs to increase its additional capital buffers by Bulgarian lev 206 million (about 105 million euro) by April 2017. While this task seems manageable, there are persisting vulnerabilities for some domestic banks and nonperforming loans in the sector remain high at almost 14% of total loans in September 2016.
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. It 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 liquid collateral.
Since 2007, Bulgaria's current account deficit has narrowed by about 25% of GDP, primarily on the back of a strong expansion in real exports. Exports with high import content and moderate added value from the domestic economy--such as refined petroleum--are an important part of total exports. In 2016, the services balance was also supported by a strong tourist season helped by external factors. While wage levels have increased considerably since Bulgaria joined the EU in 2007, the process of convergence toward European averages has been only gradual. That said, there is still significant upside potential for wages before competitiveness is affected. The total hourly labor costs (mainly wages) in industry, construction, and services are slightly less than one sixth of the EU-28 average. Bulgaria is also facing a structural constraint from demographic challenges. Its population has shrunk by nearly 15% over the past two decades, reflecting an aging society and net emigration.
Bulgaria is not part of the EU's Exchange Rate Mechanism II, the precursor to eurozone entry. Furthermore, policymakers' commitment to the currency board remains strong, as demonstrated by their track record of small fiscal surpluses or low deficits, and moderate general government debt. The currency board was introduced in 1997 in the wake of a banking crisis amid hyperinflationary conditions, which were fueled by central bank financing of budget deficits. The board successfully lowered price inflation and prevented further episodes of hyperinflation. However, the regime restricts policy response. Apart from limiting the BNB's ability to act as a lender of last resort, it restricts control over money creation. The board also does not allow the exchange rate to react in response to domestic or external conditions. As of October 2016, the BNB's reserves covered monetary liabilities by almost 1.8x.
With the adoption of the EU Banking Resolution and Recovery Directive into Bulgarian law, the failure of a bank will necessitate a bail-in of shareholders, creditors, and then a resolution fund. Only after exhausting these options would government support be needed.
The banking sector is vulnerable to external factors. However, measures by the BNB have ensured the stability of Greek subsidiaries, which together account for slightly below one fifth of the sector's assets. The BNB has taken steps to increase the liquidity of these subsidiaries, such as mandating higher deposits with the BNB, increasing the proportion of liquid assets held, and reducing exposure to parent banks. These subsidiaries could therefore be mainly affected by events in Greece if depositor confidence were to suffer. Although Bulgaria is not formally a member of the eurozone, a line of support from the European Central Bank is available to the BNB regarding any confidence-related losses arising at Greek bank subsidiaries. Details of this support, such as how it can be obtained or whether collateral would be needed, have not been released.
OUTLOOK
The stable outlook on Bulgaria reflects the balanced risks from fiscal and economic uncertainty amid the political standstill--which will potentially last for several months--against our expectation that fiscal space is preserved and economic recovery continues.
We could consider an upgrade if Bulgaria effectively addressed political and judicial governance issues, thereby boosting its growth potential; if its fiscal performance improved beyond our current expectations; and if Bulgaria managed to further reduce external vulnerabilities and liabilities.
We could lower the ratings if the domestic financial system required further substantial government support, or if outflows on the financial account resulted in pressures on the balance of payments. A weaker-than-projected fiscal consolidation path, with significant expenditure slippage or a regress on institutional advancements, could also put pressure on the ratings."