Moody's Investors Service has on September 25 changed the outlook on the Baa3 foreign and local currency ratings of the government of Bulgaria to stable from positive.

The outlooks on the A1 country ceiling for foreign currency debt and the Baa3 country ceiling for foreign currency deposits were also moved to stable from positive.

Moody's believes that the prospect of an upgrade in the next 18 months has diminished because of deteriorating external imbalances -- from already high levels -- combined with the growing prospect of a sharp slowdown in economic growth next year in the context of the spreading global credit crunch.

"Moody's is concerned that Bulgaria's outsized external imbalances leave the economy exposed to a potential reduction in external liquidity and asset price corrections, which could exert pressure on the domestic financial system," says Kenneth Orchard, Vice President/Senior Analyst in Moody's Sovereign Risk Group. "Rapid domestic credit expansion has led to current account deficits above 20% of GDP since early 2007 and external debt to GDP is now approximately 100%. Moody's believes that such imbalances will become increasingly difficult to maintain in the current global financial environment."

Moody's notes that international banks with operations in Bulgaria have been funding an increasingly large proportion of the external deficit through loans to their local branches and subsidiaries. As global funding costs rise and the European economy cools, the international banks are expected to reduce their credit extension to Bulgaria, leading to a potentially sharp slowdown of economic growth as has been experienced elsewhere in the region.

"Global developments over the past year have amply demonstrated that the unwinding of credit booms and large external imbalances can have unpleasant consequences for a financial system," comments Mr Orchard. "In Bulgaria's case, however, Moody's expects that the larger Bulgarian banks will receive liquidity assistance and/or capital injections from their parent banks as necessary."

Moody's said that the country's failure to join ERM2 was another reason why an upgrade was ruled less likely in the very near term.

"Bulgaria's inability to join ERM2 -- after initially indicating a desire to do so -- suggests that the European Commission and European Central Bank are uncomfortable with Bulgaria's financial stability, given the scale of its macro imbalances," said Orchard. "The lack of the ERM2 umbrella reduces the likelihood of ECB support in a hard landing scenario. On the other hand, other sources of EU funding could be made available."

Mr Orchard emphasises that Bulgaria's investment-grade status is secure. In a Special Comment entitled "When Macroeconomic Tensions Result in Rating Changes: How Vulnerable Are Emerging European Sovereigns?" published in May 2008, Moody's concluded that Bulgaria's rating should be able to withstand a severe but unlikely shock.

"The rating agency's decision to change Bulgaria's rating outlook from positive to stable is consistent with that conclusion and indicates that Bulgaria's government bond rating is likely to remain at Baa3 for the foreseeable future," explains Mr Orchard.

"The country's intrinsic economic, institutional and government financial strengths are expected to withstand the upcoming challenges," says Mr Orchard. "The significant decline in general government debt over the past ten years and large accumulated fiscal reserves should provide ample flexibility through any periods of fiscal stress. EU membership should likewise ensure that investment rates remain high and economic growth returns to trend, allowing a gradual convergence with the Eurozone average," Mr Orchard concludes.