EFG Eurobank: High Current Account Deficit Triggers Credit Outlook Downgrade

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EFG Eurobank: High Current Account Deficit Triggers Credit Outlook Downgrade

The domestic economy expanded strongly over the first the first three quarters of 2007 and full-year real GDP growth is now estimated at around 6.3% y/y. The ongoing credit boom and buoyant investment activity bode well for the outlook of 2008 GDP growth, but some deceleration relative to this year is expected due to base effects and slower growth in major trading-partner economies. The medium-term growth outlook remains favorable, but growing imbalances - primarily in the form of a ballooning current account (C/A) deficit - have lately increased susceptibility to sudden changes in capital inflows, reporter.gr says citing an EFG Eurobank research.

On a more positive note, strong FDI inflows more-than-fully finance the C/A deficit, while foreign exchange reserves continue to comfortably cover the monetary base. Yet, the 12%-plus REER appreciation of the lev over the past two years inevitably makes one wonder whether the sizable deficit is, at least partly, a reflection of eroding competitiveness.

More recently, the confluence of adverse domestic and external developments helped to highlight the limitations of the existing policy mix to deal with the country’s growing current account shortfall and rising net debtor position.

On the external front, heightened credit worries, the global liquidity squeeze and increased risks of ‘‘contagion’’ from the Baltics have induced a rise in Bulgarian short-term interbank rates over their euro area counterparts.

Domestically, a drought-induced rise in food prices conspired with higher energy costs to push annual CPI to multi-year highs, while the continuation of buoyant credit expansion and investment exert additional pressure to the C/A shortfall.

Along these lines, the sustainability of the Currency Board Agreement (CBA) was recently questioned. However, chances of abandonment of the CBA are limited in our view (see also our Key notes from our recent trip to Sofia: December 11, 2007).

The reasons being: (a) strong FDI inflows, which fully finance the C/A shortfall, (b) the government’s devout fiscal prudence, (c) strong political support of the currency arrangement (d) a well capitalized banking system, mostly dominated by large foreign banks.

Nonetheless, Bulgaria’s ballooning account deficit remains major medium-term macro vulnerability, especially since its dynamics show no obvious tendency of improvement in the foreseeable future. In the first eleven months of last year, the shortfall widened 65% y/y reaching €5.291bn, an amount equivalent to an alarming 18.5% of projected GDP.

In addition, the significantly higher pace and base (+19.3%y/y, EUR 18.9bn in January-November) of imports compared to exports (+11.5%y/y, EUR EUR12.3bn) leave limited hope for a sustainable narrowing in the shortfall any time soon. In further support of the latter view, note that private sector credit (in %-of-GDP) terms stood at 67.6% in December 2007, up strongly from 47.4%-of-GDP in December 2006, with around half of new bank loans to domestic businesses and households being in foreign currency.

On a more positive note, net FDI inflows in January-November 2007 amounted to €4.884bn (compared to €3.776bn in the same a period earlier), financing 92% of the current account gap over the corresponding period. According to the government’s EU convergence program, the current account shortfall is expected to remain at or above 21% of GDP through to 2010, while FDI inflows are projected at EUR 4.5bn each year.

Under the present structure of the balance of payments, the growth of exports needs to exceed import growth by a significant margin just to prevent a further widening in the current account deficit. This constitutes a rather difficult proposition given a more challenging external environment and the country´s rapid credit growth and high investment needs.

From a medium-to-longer-term perspective, a further significant deterioration in the current account deficit would inevitably require a sort of correction mechanism to help alleviate the external imbalance. Speaking of such a mechanism, two potential candidates readily come to mind: i. a ‘‘hard landing’’ of domestic demand that would help reduce import growth or ii. a change in the present exchange rate regime, aiming to recoup any competitiveness losses inflicted by the lev´s real appreciation.

The main scenario remains that Bulgaria will enter ERMII with the current CBA, though analysts now think that the 2010 targeted euro adoption date will be pushed out by at least two years given growing headwinds to the inflation outlook.

Furthermore, they project that the current trajectory of strong domestic demand will continue, Emerging Europe Monthly, February 2008, Page 18 of 25 at least for a few more years, but we see rising risks to the medium-term growth outlook stemming from the widening external imbalance.

With regard to the quality of Bulgaria’s C/A financing, this appears sound for the time being, as it mainly depends on FDI, a generally long-term and non-easily reversible form of funding. Moreover, due to the underdeveloped state of domestic financial markets, Bulgaria is much less susceptible to the risk of a sudden exodus of short-term speculative capital than most of its EMEA peers. Overall, analysts see little risk of a sudden dry-up of FDI inflows in the foreseeable future.

Longer-term, to the extent that EU convergence will entail a gradual erosion of Bulgaria’s low-cost production advantage, a shift of focus towards more value-added exports as well as reforms in the domestic product and labor markets will be needed to repair adverse balance of payment dynamics.

On the inflation front, CPI spiked to 13.1%y/y in September, after falling to nearly two-year lows of 4.1%y/y in March. December’s reading stood slightly lower at 12.5%y/y, but was the highest year-end figure since 2000.

In December 2007, food and non-alcoholic beverage prices (35% weight in CPI basket) rose by 21.1%y/y, with strong gains also recorded in the transport and housing, water, electricity, gas & other fuels sub-components (up 15% y/y and 8.2% y/y, respectively) as a result of elevated domestic energy prices.

Analysts expect no significant deceleration in domestic CPI during the first half of this year as energy prices will likely remain near their current elevated levels and increases in domestic gas prices (+9.9% in both H1 and H2) and excise duties are likely to add to inflationary pressures. Nonetheless, they expect a retreat of headline inflation towards 7% by year-end on the back of favorable base effects in H2 08.

The government’s commitment to tight fiscal policies has greatly enhanced the sustainability of the CBA in recent years. Bulgaria has been running on fiscal surpluses since 2003.

In 2007, the budget recorded a 3.8%-of-GDP surplus, outperforming an initial budget target of a 3.5%-of-GDP surplus on the back of better-than-expected revenues following the introduction of a flat corporate tax of 10%. However, like Romania, Bulgaria has been accused of underestimating budget forecasts.

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